Cap rate discusion

Capitalization Rate
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.

CAPITALIZATION RATE
DEFINITION:
The Comparative Rate used to determine the capital value of an income stream. In real estate, the capitalization rate is used to determine the value of a property based on the Net Operating Income.
FORMULA:
(Net Operating Income / Original Property Value) * 100
($201,556 / $5,250,000) * 100 = 3.84%
EXAMPLE:
In order to make a quick valuation of a property, you can divide the Net Operating Income by the Capitalization Rate. The Net Operating Income for this property is $201,556 per year. Assuming the Capitalization Rate is 3.84%, the value of the property would be estimated at $5,250,000.
TIPS:
Capitalization Rates are an important rate of return to consider when purchasing a property. With accurate information regarding Net Operating Incomes, Capitalization Rates give you a means to access which properties yield the most competitive rate of return in your Market Area.

Beyond understanding the formula of a cap rate, you need to understand that it is just a "snapshot" of a properties potential. I have seen many properties with high cap rates that in fact make only a very small return, and vice versa. You have to fully analyze a property before you figure out if it’s a good deal or not based on return. Many times the new higher taxes are not taken into account, meaning it could drop the return significantly. Other times it might be that there is a huge rental increase soon, or the possibility of turning a 50% occupied building around and making a large increase to your bottom line. All this must be factored. Don’t ever buy a property based solely on a high/low cap rate without understanding how all the numbers got there in the first place.

Completly agree with David. I often think too many people misuse cap rates soley assuming that they are return on an investment. This just isn't true. There are far too many factors that go into actual return. Cap rates are a market perception of where a risk / return rate should be based upon the opportunity cost of capital in similar investments. And knowing if something is a good investment based upon just a cap rate is near impossible. While it can be used to compare surface level returns, it needs to be just another tool in a full range of risk analysis on any investment property

For a comprehensive discussion of cap rates (too lengthy to post here) see my LoopNet blog, Understanding Cap Rates, at the link below, or simply click on the View Profile link to your left.

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