What is a Cap Rate and Why It Matters
Updated: Jun 22, 2022
A cap rate is a snapshot of a property’s value at a particular point in time. It is used as a quick way to estimate value based on its capacity to generate revenue and returns according to current market conditions where the property is located. Investors commonly use the cap rate as a preliminary gauge of a property’s ability to perform. While it is a quick and convenient way to estimate a property’s value, it is not comprehensive because it does not take into account any debt service (mortgage) that may be used to acquire the property. However, by using a cap rate for the initial evaluation, an investor can see whether the property is priced or overpriced without much effort. This is especially helpful when there are a lot of properties to evaluate. It gives an investor a way of narrowing down the list to properties priced to the market and, therefore, worth a closer look.
Cap rates are also helpful when a property owner considers selling their property. They can use a market cap rate, which is the cap rate at which comparable properties are trading in the market, to determine what their property might sell for under current market conditions. The market cap rate can be found by contacting local brokers or through various market reports often made available by the larger commercial real estate brokerages. Market cap rates can also be found through services like CoStar, ALN, and NAA, which can vary in cost from free to a costly monthly subscription.
To calculate the cap rate of a particular property, you must first determine the Net Operating Income (NOI), which is income after expenses, but before debt service. You then take the NOI and divide it by the market cap rate to arrive at the estimated value, so if a property’s NOI is $100,000.00 and the market cap rate is 5%, then:
$100,000.00 / 5% = $2,000,000.00 estimated market value
The finance equation for this is:
Cap Rate = Net Operating Income (NOI) / Sales Price
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