Capitalization Rate is a percentage that relates the value of an income-producing property to its future income expressed as net operating income divided by purchase price. Also referred to as ‘Cap Rate’.
This relationship between Value and Income is often expressed in the formula I/V = R or I= RxV where I is the NOI (Net Operating Income), R is the cap rate, and V is the Value of the property. It may also be expressed as V=I/R.
You have used rate formulas before, such as d=(r) x (t) for the relationship between distance traveled (d), average rate of speed (r) and time traveled (t). If you drive 150 miles to Indianapolis in 3 hours, then what is your average rate of speed? Easy, 150miles/3hours=50mph.
If your average rate of speed is 60 mph, then how long will it take you to reach Indianapolis?
The formula becomes d/r = t. 150miles/60mph = t or t=2.5 hrs. Therefore, as the rate of speed increases, the time will decrease to travel the same distance. Think of r up, then t down. As t goes up, r comes down. T and r are inversely proportional, their product is a constant.
When you are asked to determine the value of an income producing property, at the present time, namely with the current income, one way to approach the value is to use the relationship between Value and Income. In order to use the formula above, you need to determine the cap rate of similar properties, which have sold in the same market. So then, let us suppose you have a prospective seller who has an income producing property which has an NOI (Net Operating Income, which is gross income less vacancy loss less expenses) of $300,000.00. Next, you find comparable sales of other similar income-producing properties, which have sold and determine that the cap rate is an average of 10%. Then, you could use the formula I/R = V and reasonably conclude that the value of the subject property would be $300,000./.10 = V or V=$3,000,000.00.
Let us say the cap rate found in the market place was 6%, then the Value would be:
V = I/R or V=$300,000./.06, or V=$5,000,000.
If the market shows a cap rate of 12%, then the value would be $2,500,000.
So, which cap rate is better, the higher or lower cap rate? It depends on whether you are buying or selling.
With income constant, the higher the cap rate, the lower the value, likewise, the lower the cap rate, the higher the value. Think R up, then V down. If R down, then V up. They are inversely proportional, their product is a constant.
Feb 3, 2011