Real Estate Articles » Property Analysis

Understanding Cap Rates (Capitalization Rates)

By: Robert McComb
Submitted: 10:15AM on Monday 25 August 2008

To understand the real story behind the income potential of a property, we need to understand the capitalization rate (cap rate). The cap rate is a benchmark used by investors to decide whether or not a property is worth further consideration by allowing the comparison of a series of properties that may be dissimilar in value, size, and price.

While the gross rent multiplier tells us the quantity of the rental income, the cap rate tells us the quality of the income. In other words, it tells us how much of the gross income is left after expenses to pay the mortgage and pay a yield to the investor.

In short, what we are doing is boiling down a series of variables to a common denominator that acts as a kind of a filter to see whether or not a closer look at a property is warranted.

Here is how we calculate a cap rate:

1. We start by finding the annual gross scheduled income by multiplying the gross monthly scheduled income by twelve and then subtracting the vacancy factor.

The vacancy factor is market driven and may be any of the following: the actual current vacancy, the historical vacancy based on the past few years, or the projected vacancy after a lease up. If you are uncertain about what vacancy rate to use, call a lender who lends on the kind of property you are considering and ask which rate it uses. In any case, it must be realistic, so accuracy is important.

2. Next, we add any income from other sources to the gross scheduled income. The sum of these amounts is known as the gross adjusted income.

In an apartment complex, other sources of income might include laundry income or garage or storage unit rental payments; in large complexes it could also include pay phone and vending machine income. With office, industrial and retail properties, additional income might include income streams from parking, billboards and /or cellular antenna rental.

3. Next, we need to subtract all usual and recurring operating expenses from the gross adjusted income. The resulting number is known as the net operating income (NOI).

The operating expenses that need to be deducted include property taxes, insurance, management costs, utilities, maintenance, security, trash removal, landscaping, etc. They also include repairs and any capital funds set aside for future big-ticket repairs, replacements, or renovations. (Note that we have not deducted mortgage payments or income taxes due in our calculation of the NOI.)

4. The NOI is then divided by the sales price; the result is the capitalization rate or cap rate.

Let’s review those steps in a more succinct, visual way:
1. (Gross Monthly Scheduled Income x 12) – Vacancy Factor = Annual Gross Scheduled Income
2. Gross Scheduled Income + Income from Other Sources = Gross Adjusted Income
3. Gross Adjusted Income – Operating Expenses = Net Operating Income (NOI)
4. NOI / Sales Price = Cap Rate

Once you have the cap rate, you can compare properties currently on the market, properties that have recently sold (called comparable sales), and expired listings that have been removed from the market unsold. It is important to understand that as cap rates go down, the price of the property will be higher. In other words, the cap rate would be equal to the percentage rate of return on the property if it were purchased for all cash, without any loans. Therefore the higher the cap rate, the higher the rate of return on our investment, which means we have less money at work in the investment, as a result of having purchased it a lower price. There are other filters we can use to compare dissimilar properties, but none work as well as the cap rate.