Properly Understanding Capitalization Rates

Many real estate investors determine the value of an income property by using the capitalization rate, although it is a simple computation, it is very misused!

Many people quote deals based on the cap rate by taking the yearly Net Operating Income (NOI), and dividing it by the sales price:

Say the property has an NOI of $250,000, and the price is $3,000,000.

$250,000/ $3,000,000 = 8.3% cap rate

The cap rate represents projected return for one year as if the property were bought with all cash. In order to correctly calculate the cap rate, and get an apples to apples comparison, you must know the correct income and expenses for the property, and that the calculations of each were done in the exact same way. Many times, brokers will show the income or expenses as a snapshot of one month and then calculate the cap rate. Obviously, this is problematic as expenses may be different depending on the time of year. January may have expensive snow removal costs, or summer months might require additional watering, or there might be a lower occupancy during months when students are gone. It is imperative that you have a good expense numbers and income numbers prior to calculating the cap rate.

Always remember that brokers and sellers will spin the numbers as much as possible. When doing due diligence to verify these numbers, insist on seeing current leases and know that prior to selling, sellers will often give renters special incentives to live in the property in order to boost occupancy levels. For this reason, you may want to calculate your expenses and income numbers going back a couple of years, or just use an average per unit expense number as quoted by the management company.

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