Cap Rate: How To Compute and Use This Popular Return in Your Next Rental Property Analysis

One of the most well known and commonly-used returns real estate investors rely on for a rental property analysis is the capitalization rate (or cap rate).

(1) Because the cap rate reveals whether or not the value of one particular rental property measures up to the value of similar income-producing properties in the local market, and (2) because it indicates whether or not the property in question generates ample profits to make it a lucrative purchase for an investor.

What is a Cap Rate?

Capitalization rate is the rate that the future income is discounted back to determine the present value of that income.

In other words, whatever investment a real estate investor makes to purchase the property is considered the present value of all future earnings the investor expects to collect from owning that property. And in this case, the capitalization method enables real estate specialists to measure what the value of those future gains are worth today.

Okay, but that description is going to mean little to those of us slugging it out in the real world, so let's steer away from the classroom definition and put it in terms we recognize.

"Capitalization rate expresses the relationship between a property's value and its net operating income"

For those of us actually working with rental properties, think of it this way.

Cap rate expresses the relationship between a property's "present value" (perhaps its current market value or listing price) and it's "future value" (the income it produces after operating expenses but before the mortgage payment and income taxes).

Let me illustrate three different situations that you might want to use this method during a real estate analysis along with how to make the computation.

1) Arrive at Property Value - Say you were called by a seller asking you to determine the fair market value of his apartment complex so you can list it for sale. You deduce that the subject property generates $34,705 net operating income and based upon your recent market research you discover that other properties comparable in configuration and condition have been selling at an average cap of 7.25%.

Here's how you determine a fair market value for the property you are about to list for sale:

Net Operating Income / Capitalization Rate = Price

34,705 / .0725 = $478,690 (the seller forces you to list at $550,000)

2) Compute a Cap Rate - Okay, now let’s assume that you are an investor or agent who just spotted the listing illustrated above.  However in this situation you need to discover whether you're in agreement using the $550,000 selling price based on its capitalization rate. Given that the property's net operating income is $34,705 and the average cap rate for similar apartment complexes is 7.25%, you simply want to determine whether the cap for the listing property is in line with the market average.

Net Operating Income / Price = Capitalization Rate

34,705/ 550,000 = 6.31% (lower than the market so it is over-priced)

3) Determine Net Operating Income - Say you just called for the marketing package on the property illustrated above but all you know is what the listing agent pitched. That the asking price is $550,000 with a 6.31% cap. In this case you want to know how much net operating income you can expect that the property produces.

Price x Cap Rate = Net Operating Income

550,000 x .0631 = $34,705