The capitalization rate, or cap rate, is used to compare an income property with other properties that are similar to the subject.  It can also be used to value a property based on the income it generates.

The cap rate explained simply is the projected return for one year if the property was purchased with no financing, all cash transaction.  The cap rate is calculated by taking the property’s net operating income, or NOI, and dividing it by the fair market value of the property, the FMV.  A higher cap rate is more advantageous to a buyer.  You can view my post on commercial lending to learn how to calculate the net operating income, or NOI.

Calculating the cap rate on a property gives you an additional measure of value in addition to appraisals.  An appraisal of a property is going to give you a value based on comparable sales.  Typically, this is what you could sell the property for on the open market, and the comparables are like type buildings based on physical characteristics.  The cap rate, however, allows you to evaluate a property based on the income of the subject property, and may indicate a value different than a sales comparison appraisal would.

When calculating your cap rate, it is very important to have accurate and true numbers.  A small difference in cap rate can indicate a larger difference in value of a property than it may seem.  Let’s look at a couple examples to see how this actually works.

For this example, we are going to assume a subject property with a net operating income, or NOI, of $100,000.  If the market value of your property is $1,250,000, your cap rate would be 8%.  The numbers work like this:

Capitalization rate = NOI/FMV

Capitalization rate = $100,000/$1,250,000

Capitalization rate = 8%

Another example can help you estimate the value of a property using a cap rate formula.  Using the same example as above, let’s say you are looking at purchasing a property with a net operating income, or NOI, of $100,000.  By researching the area, you conclude the average cap rate is 7%.  By working backwards, we can come to a value estimate on the property as follows:

FMV = NOI/Cap Rate

FMV = 100,000/7%

FMV = $1,428,571

From these two examples, we can see what a large difference in value a seemingly small difference in cap rate can make.  A 1% difference in cap rate indicates an almost $200,000 spread in market value for the above mentioned property.  Again, this example stresses the importance of having accurate information when making your calculations, as a small discrepancy can make a big difference.