Using capitalization rate to determine income property value and profitability is popular amongst those who work with real estate investment property for two reasons: It reflects the net operating income (gross operating income less operating expenses), and it is easy to compute.

As a result, capitalization rate (or cap rate) is regularly used in two rental property scenarios: To determine whether a property meets with a buyer’s investment goal, and to determine a property’s value based upon cap rates for similar properties in a given area.

Before we look at our examples, consider the formulas

Capitalization Rate = Net Operating Income/Property Value

Property Value = Net Operating Income/Capitalization Rate

Let’s say a real estate investor wants you to locate several multifamily properties priced at about $500,000 with a cap rate of 8.0%. You find two properties listed at $490,000 and $510,000 (so far so good). However, neither listing agent was kind enough (or knowledgeable enough) to include a cap rate.

Your next step is to see whether the agents show the listed property’s net operating income. Again, no such luck, thus requiring you to call the listing agent and ask for the net operating income. If you get a silent response, ask for the income and operating expenses and compute the net operating income yourself.

Several phone calls later, you determine that the property listed for $490,000 has a net operating income of $40,000, and the other at $510,000 of $43,000.

Okay, now you’re ready to compute the capitalization rates. In each case, divide the net operating income by the sale price. $40,000 divided by $490,000 equals 8.16%, and $43,000 divided by $510,000 equals 8.43%. Guess what, you have a match; both properties meet the investor’s cap rate and can be considered of interest.

In this next situation, let’s say you’re preparing a listing presentation and want to advise the owner of a commercial office complex what the property is worth based on similar properties in the area. You’ve already established (because you asked the owner for the property’s income and expense statement) that the net operating income is $65,000.

Several hours later, you determine that a few comparable properties sold within the past six months at an average cap rate of 7.0%, and a few more are currently on the market at around 6.8%. You decide on a cap rate of 6.8% to establish the value of the owner’s office complex.

In this case, divide the net operating income by the capitalization rate. $65,000 divided by 6.8% equals a property value of $955,882 that you round up to $960,000 and present to the owner.