The capitalization rate otherwise knows as a cap rate, is an economic indicator used in understanding and valuing income producing property. This figure, which is expressed as a percentage, is a ratio of the net operating income (NOI) and the value or sale price. This figure helps to identify the underlining value and potential return of an asset and is the rate at which the net operating income recapitalizes the value of an asset on an annual basis. Here is the formula:
Capitalization Rate = Net Operating Income / Current Market Value
For Example, if a couple buys a apartment complex in Texas with an annual net operating income (NOI) of $100,000 for $2,000,000, the cap rate equals 5%.
See breakdown here: $100,000 / $2,000,000 = 5%
If the asset is producing 5% of its value in income every year, essentially you are saying the asset will pay for itself in 20 years. If the asset was purchased at a 10% cap rate, the asset would pay itself off in half the time: $100,000 / 10% = $1,000,000.
What determines a Property’s Cap Rate?
There are many factors which come into play when determining the market cap rate but the simplest way to understand it is the level of certainty at which the income will be received, which is based on the credit of the tenant, and their ability to pay as well as the demand for the units/suite.
Cap rates vary by property type and geography. For example, an apartment complex in California may trade at a 3% cap rate while a similar property in Texas will trade at a 6% cap rate. An apartment complex in Houston may trade at a 6% cap while a retail center down the street trades at a 7% Cap.
When valuing or appraising residential properties comparable sales are used and adjustments are made to determine a value based on square footage. Similarly, in commercial real estate, cap rates of comparable sales in the local market help to determine the market cap rate.
Other variables that come into play when determining the cap rate include the site’s location, physical condition and occupancy.
The link between NOI & Cap Rates is critical to understand for every real estate investor and helps determine the actual value of a property.
Keep in mind that this is a highly simplified discussion of a complex topic and that there are various risk factors and formulations used for property comparisons. For more information, or a cap rate valuation of your property, contact the experts at MarketSpace Capital by emailing email@example.com