Cap Rates and How they work?Summary of using cap rates for valuation and investment purposes
What is Cap Rate?
Cap rate is used in the analysis of commercial real estate investments. This provides a “valuation” of the subject property. It also provides the investor an estimate of the number of years needed to recover their initial investment. The calculation is done by dividing NOI (Net operating income) / current property value.
Cap rate calculation example
As an example, lets take a property that generates $100,000.00. This property is purchased for $1M dollars. Using the example above : $100,000 /$1M is 10% (.10). You can also figure value another way. Let’s say your property generates $80,000 and expenses are $10,000. Your Net income is $70,000 and the investor wants to set it at a 7 cap. $70,000/ .07 equals an asking sales price of $1M.
There are 3 underlying assumptions that limit the calculation’s usefulness.
1. NOI fluctuates and isn’t static in a real market situation.
2. Time value of money is not in the calculation.
3. Financial leverage is not in the calculation.
The investor should apply the discount rate to yearly income streams. This would be net of any debt service to estimate a good value.
- The cap rate is arrived at by the calculations is the expected return over 1 year.
- Financing is not incorporated into the calculation
- When cap rate is known, the NOI is divided by an this number