Capitalization rate (or “Cap Rate”) is a real estate valuation measure used to compare different real estate investments. Although there are many variations, a cap rate is often calculated as the ratio between the net operating income produced by an asset and the original capital cost (the price paid to buy the asset) or alternatively its current market value.
Just like all homes in a given part of a town do not have the same value, there is not a standard capitalization rate – I often work with real estate professionals who do not view it that way –
Capitalization rates, or cap rates, provide a tool for investors to use for roughly valuing a property based on its Net Operating Income. For example, if a real estate investment provides $160,000 a year in Net Operating Income and similar properties have sold based on 8% cap rates, the subject property can be roughly valued at $2,000,000 because $160,000 divided by 8% (0.08) equals $2,000,000. A comparatively higher cap rate for a property would indicate less risk associated with the investment (increasing demand for the product), and a comparatively lower cap rate for a property might indicate more risk (reduced demand for the product). Some factors considered in assessing risk include creditworthiness of a tenant, term of lease, quality, condition and location of property, and general volatility of the market.
If you hav not already done so you can look at data from comparable properties that may have sold recently in the area, and determine their cap. rate and decide if that is suitable for other properties.
If you are not familiar with Capitalization Rates there is a great deal of information online.
Oct 5, 2015