What's a Cap Rate?
Lately business owners who want to buy have been asking me about capitalization (or cap) rates.
What is it? What does it mean?
Basically it is just one of many methods to assign real estate value. It can be confusing, because it is not interest. Rather it is a rate of return. According to Modern Real Estate Practice in Illinois, This rate of return is called a capitalization (cap) rate that compares the relationship of net operating income to the sales price (Galaty, Allaway, Kyle, page 389).
So what does it mean to you. It's an indication of the property value. As a buyer, you want to buy at a higher cap rate. The seller wants to sell at a lower cap rate. The common calculation is to take the Net Income divided by the cap rate and get the property's value.
Net Income
----------- = VALUE
Cap Rate
Basically it is just one of many methods to assign real estate value. It can be confusing, because it is not interest. Rather it is a rate of return. According to Modern Real Estate Practice in Illinois, This rate of return is called a capitalization (cap) rate that compares the relationship of net operating income to the sales price (Galaty, Allaway, Kyle, page 389).
So what does it mean to you. It's an indication of the property value. As a buyer, you want to buy at a higher cap rate. The seller wants to sell at a lower cap rate. The common calculation is to take the Net Income divided by the cap rate and get the property's value.
Net Income
----------- = VALUE
Cap Rate
posted by VJG @ 4:35 PM
2 Comments
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2 Comments:
A capitalization rate is the return 'on' and 'of' your money. It is implicitly the return you would get from cash flow from operations AND from the sale of the property at reversion.
Cap rates are the equivalent of 'multiples' in small apartment or hotel valuation.
If you are interested check out one way, albeit inexact, to arrive at a capitalization rate via the 'Band of Investment' method. It derives a capitalization rate from the returns to debt and equity.
Cap Rate is the Return on Investment if you purchased that investment using all cash.
In other words, if you purchased an Apartment Building for $1M and at the end of 1 year, after you've paid all of your operating expenses such as; Taxes, Insurance, Management, Maintenace, Utilities & Repairs, you have $80,000 left over to put in your pocket, that building would have paid you a Capitalization (Cap) Rate of 8%. $80K/$1M = .08 or 8%.
This will allow you to compare apples to apples. Financing is not a factor. Since different purchasers maybe able to finance at different rates and terms, you don't want to use that factor in determining the value of a property.
www.ApartmentMentor.com
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