One of the most important terms you will come across in the investment real estate world is “Capitalization (Cap) Rate”. This is the rate of return on an investment, based on the income that the property is expected to generate.
The cap rate is calculated by dividing the Net Operating Income (NOI) by the current Market Value. The NOI is the annual income of the property, minus all operating costs.
The formula is as follows:
Capitalization Rate = Net Operating Income / Current Market Value.
When it comes to the Cap Rate, a lower number is actually a good thing – the lower the Cap Rate, the higher the Value. The higher the Cap Rate, the lower the Value. And all of this hinges on the NOI, as such:
Why is the Cap Rate useful? Well, it can also be referred to as the IRV Formula, and can also be used to figure out the Value if you have the NOI and the average Cap Rate for the area, or the expected NOI if you have the Value and the Cap Rate, like so:
This information can be used to compare and value properties, to determine an asking or offer price, to track the performance of a given property over time, etc.
It can also be used to roughly calculate the payback period of an investment by dividing 100 by the cap rate when expressed as a whole number (for example, a property with an 8% cap rate would have an expected payback period of 100 / 8 = 12.5 years.
All in all, although it should not be relied on exclusively to determine whether or not a property is a worthy investment, it is definitely a very useful tool to set you on the right track!
– Dana Snow, Broker of Record