Real Estate Investing Cap Rate Method
The Capitalization Rate or Cap Rate is a ratio used to estimate the value of income producing properties. Put simply, the cap rate is the net operating income divided by the sales price or value of a property expressed as a percentage. Investors, lenders and appraisers use the cap rate to estimate the purchase price for different types of income producing properties. A Market Cap Rate is determined by evaluating the financial data of similar properties which have recently sold in a specific market. It provides a more reliable estimate of value than a market Gross Rent Multiplier since the cap rate calculation utilizes more of a property's financial detail. The GRM calculation only considers a property's selling price and gross rents. The Cap Rate calculation incorporates a property's selling price, gross rents, non rental income, vacancy amount and operating expenses thus providing a more reliable estimate of value.
From an investor's or buyer's perspective, the higher the cap rate, the better. Investors expect a larger return when investing in high risk income properties. The Cap rate may vary in different areas of a city for many reasons such as desirability of location, level of crime and general condition of an area. If you would like to find out what the cap rate is for a particular type of property in a given market place, check with an appraiser or lender in that area. Be aware that the frequency of sales for commercial income properties in a given market place may be low and reliable capitalization rate data may not be available. If you are able to obtain a market cap rate from an appraiser, lender or property management company for the type of property you are evaluating, check to see if the cap rate value was determined with recent sales of comparable properties or if it was constructed. When adequate financial data is unavailable, appraisers may construct a cap rate through analysis of its component parts thus reducing the credibility of the results. Cap rates which are determined by evaluating the recent actions of buyers and sellers in a particular market place will produce the best market value estimate for a property.
If you are able to obtain a market cap rate, you can then use this information to estimate what similar income properties should sell for. This will help you to gauge whether or not the asking price for a particular piece of property is over or under priced.
After paying all expenses, except the principal and interest mortgage payments, the remaining cash flow is known as the Net Operating Income or (NOI). NOI is most commonly used in conjunction with a cap rate to determine property value.
Net Operating Income = CAP RATE%
Purchase Price
Income (NOI) = Investment Value
CAP RATE
Pros: The main advantage of using a cap rate is its simplicity. It also accounts for vacancy and operating expenses.
Cons: The reliability of using a cap rate is limited because it only looks at a one-year forecast and does not take into consideration any financing or tax implications.
The Cap Rate model is just one way to examine a rental property's potential benefits, when buying property you should consult with real estate and tax professionals to ensure the validity of the analysis
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