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What Is A Cap Rate?

Cap Rate Definition

What is a Cap Rate? – A Cap Rate or Capitalization rate is a commercial real estate formula that is a widely accepted valuation method typically used for investment and commercial real estate

Cap Rate Calculation

The formula to calculate the cap rate is Net Operating Income divided by the property value. 

Cap Rate = Net Operating Income/Value

You can also use the cap rate formula to solve for value by dividing the Net Operating Income by the cap rate to get the value

Value = Net Operating Income/Cap Rate

For example, if a property sold for $5,000,000 (Five million dollars) and had a stabilized net operating income (NOI) of $500,000, the cape rate would be $500,000 divided by $5,000,000 or 10% .

How A Cap Rate Is Used For Property Valuation

An appraiser can estimate the market value of a property by using the market capitalization method.  By taking the current net operating income and recent sale price of a number of local comparable properties the appraiser can calculate the areas market cap rate.  By Dividing that NOI by the average area cap rate the appraiser can calculate a properties value. 

Comp Address     NOI                           Sale Price      Cap Rate
123 Main St          $1,000,000            $15,000,000      6.6%
234 Main St          $800,000               $ 11,000,000      7.2%
567 Main St          $1,350,000            $ 19,000,000      7.1%

By taking the 3 comps above and averaging them, the average cap rate for these 3 comps in the area is 6.97%. Once we have the average cap rate of 6.7 and look at the Net Operating Income of our subject property which for our property example will be 8910 main street with a net operating income of $750,000 divided by our average comp rate of 6.97 would give us a property value of  $10,760,000

What Does A Cap Rate Tell Us?

The cap rate gives the the annual percentage return an investor would receive. For example if an investor paid $10,000,000, ten million dollars for an investment property with a cap rate of 6.97%, they should have an all cash return at the end of the year of 6.97% or $697,000 dollars. If you would like help evaluating your next investment property, call 800-826-5077

What Is A Good Cap Rate?
A good cap rate for a seller would be the lowest possible cap rate, yielding a higher sale price.

On the other hand if you are purchasing a property you want the highest cap rate possible yielding you the highest return on your investment. 

Whether you are buying or selling the easiest way to determine a good cap rate is to run an analysis on comparable properties in the area so you know what the actual average cap rate is in your market.

When should I use a Cap Rate?
A Cap Rate is typically used if you are buying or selling commercial real estate to 1. Find the value of properties in your area, 2. Determine the return on a property that you might be looking to purchase, 3.  Show you market trends by looking at historical cap rates in your area and whether they are increasing or decreasing. Remember the more informed you are the better the investment decision and the least chance for error, especially on a commercial investment purchase.

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