Capitalization Rate (cap rate)
Definition: Ratio of Net Operating Income (NOI) to property asset value.
Example: Property listed at $1,000,000 and generated an NOI of $100,000, then the cap rate would be $100,000/$1,000,000, or 10%.
In simple terms: The cap rate above represents is the projected return for one year as if the property were bought with $1,000,000 cash.
Due Diligence: In looking at an investment property be sure to verify the income and expenses but remember that your management plan may be different from present ownership and may affect the results. Also, to the extent possible, investigate anomalies. Consider that present owners may be taking management fees, unspecified professional fees, auto expenses, office expenses, etc. Consider also that some expense items may not include labor charges. Use your own projections to determine NOI under your management. Two potential owners could arrive at two different NOIs and both can be right. Remember – the value of the deal is up to you!
Operating Expenses: Do not include debt service or mortgage interest and service in calculating NOI.
Appraisals: Appraisers use a three pronged method of estimating value on real property. The method of estimating value includes; the replacement value method, the income approach method and the comparable sales method. The appraisal will represent the market conditions plus the typical requirements of the investor and the financing conditions of lenders active in the real estate market.
Derived Capitalization Rate: the income approach is typically the most important. Called the band of investment, it estimates the present value of future potential cash flows. It covers the return required on both the equity and debt service. To get this number two important pieces of information are required, the terms of financing available to you and your desired return on investment.