Let’s examine what a cap rate is and how it allows investors to evaluate their rate of return. There are many ways to value real estate. It consists of appraising the land and building, comparing comparable properties, or calculating the value based on the rents being generated.
The later method is where the capitalization rate (or “cap rate”) comes into play. The cap rate (expressed as the ratio of the property’s net income to its purchase price) allows investors to compare properties by evaluating a rate of return on the investment made in the property. By examining the actual income (or rent) that the property generates and then deducting operating expenses (not including debt costs), the investor arrives at a property-level net operating income (or NOI). Once you determine the NOI, you simply divide that by the cost of the property or the price you are buying or selling the subject building for.
Calculating Cap Rate
While this method of valuation may appear simple, the use of the tool can be extremely valuable. Also, it’s important to mention that a Cap Rate does not show the full picture of the investment. It’s a only a snapshot of the first year’s returns and should not be treated as the only factor to consider. In general, a lower cap rate indicates there is less risk associated with the investment (due to a stronger tenant, such as a national chain or increased demand) and a higher cap rates can be associated with higher risk alternatives.
Real estate investors rely upon a variety of types information when negotiating for income producing properties – for instance, the desirability of the property’s current location and/or any prospective changes in the neighborhood are two common factors.
Looking for more information on cap rates? Click HERE to be forwarded to a Wiki How article with great simple diagrams – enjoy.
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