What Is Cap Rate?
Capitalization rate, “or cap rate,” is a calculation tool used to value real estate—mostly commercial and multi-family properties. Cap rate is the net operating income (NOI) of the property divided by the current market value or purchase price. NOI equals all revenue from the property minus all necessary operating expenses.
Determine Property Income That Justifies the Asking Price
If your client knows the asking price of a property and the current cap rate for similar properties, you can calculate the net rental incomes necessary to justify the asking price. For example, if a property sold for $1,000,000 and the total revenue after expenses or NOI was $150,000, the cap rate would be 15% (150,000/1,000,000 = .15, or 15%). What if other properties in the neighborhood also sold for a similar amount but only yielded $100,000 in NOI? The cap rate for those properties would be 10%. A lower cap rate in this example could be the result of a lower NOI due to higher operating expenses (leading to a lower profit from the investment) or lower revenue earned on the properties.
Other Calculations to Value a Real Estate Investment
Part of your value as a real estate agent or broker is to assist them in determining the true value of a property. Using the capitalization rate is one of several valuation tools that can provide your clients a good understanding of what a property is worth.
Net Operating Income
Net operating income is the net result of revenue from the property minus operating expenses. However, NOI is calculated before taxes and doesn’t include principal and interest payments on any loans.
Net Rental Yield
The rental yield is similar to NOI but takes into account taxes. You can calculate the monthly rental income minus monthly expenses and tax payments. From there, you divide that figure by the market value price to get net rental yield. It’s important to include repair costs and upkeep as well.
Gross Rent Multiplier
Gross rent multiplier (GRM) is calculated by dividing the market value of the property by the annual gross income. The GRM figure gives you an approximate return on a property without factoring in expenses. The GRM is easy to calculate but isn’t a very precise tool for ascertaining value.
Cash Flow of a Rental Property
Cash flow analysis is helpful in determining how much monthly income (or cash) is left over after repair costs, expenses, and a vacancy rate. Properties might sit idle for a few months and vacancy should be factored into the analysis. Cash flow analysis is helpful in providing the monthly income to earn back your initial cash outlay for the down payment or any repairs.
Gross Scheduled Income and Effective Gross Income
Gross scheduled income (GSI) helps you know what income will be realized if a property is fully occupied and all rents are collected. Take the number of units times annual rent for GSI. Once you know the GSI of a real estate investment property, we arrive at the effective gross income by subtracting out the estimated annual losses due to non-payment or vacancies.
Depreciation of a Rental Property
You can calculate the depreciation of a building by deducting out the value of the land and dividing the building value by 27.5 years for annual depreciation. For example, a building is valued at $245,000, so we divide $245,000 by 27.5 years, which equals $8,909 in annual depreciation.
Breakeven Ratio for Rental Property
Lenders use the break-even ratio as one of their analysis methods when considering providing financing for a real estate investment property. The breakeven ratio factors income gross rental income, total debt payments, and all operating expenses. Too high of a break-even ratio is a cautionary indicator.
