Generally, commercial real estate investors utilize Cap Rate, or Capitalization Rate, more than residential investors. However, it’s great for valuation of multifamily properties, even duplex to four-plex properties. So, what is Cap Rate? One definition is: “Capitalization rate is the rate at which you discount future income to determine its present value.” That’s true, but it just seems clearer to most investors if we define it a bit differently.
It’s a number that tells us the percentage of the purchase price we’ll recoup each year from the net income generated by the property. In other words, if we pay $100,000 for a duplex, and our net income after all expenses is $9,400, then we divide the income by the price/value and we get .094, or 9.4% for the cap rate. We’ll recoup 9.4% of the cost of the property each year if expenses and income are steady.
That just seems like a more understandable and useful way to think about cap rate. We can see that the higher the cap rate, the faster our profits will recoup our purchase price. So, the higher the cap rate, the better the investment generally. Capitalization rate is a great way to compare investment properties. Using the cap rate at which similar investment properties recently sold, we can determine what a prospective property is worth, independent of the asking price.
Let’s take a look at an example, a six unit apartment project we’re considering buying. We gather data for recent sales of similar apartment projects, and from their NOI (Net Operating Incomes) and their sold prices, we find that the average Cap Rate for these properties was 10.7%. The project we’re considering buying has an asking price of $365,000, and according to the financial data the NOI is $35,040. We divide the net income by the asking price and find that the cap rate based on asking price is .096, or 9.6%.
Using that number, we would consider this property over-priced for its income yield when compared to recently sold similar properties in the area. If we divide the $35,040 income figure by the prevailing 10.7% cap rate ($35,040 / .107), we get a true value of the property of $327,477
This isn’t hard science, and there are factors that can change or be changed to improve a property’s cap rate. In fact, if you find problems with how the current owners are handling their expenses, and you believe you can cut them significantly, you may want to use your anticipated expenses for the first year you’ll own the property to calculate the cap rate after your purchase. Or, maybe they’ve been charging less rent than they could in the current market. Raising rents and/or cutting expenses can have a considerable effect on cap rate and value.
We’re not suggesting that you pay the price you determine the property would be worth if you cut expenses and/or raised rents immediately. Let’s say that you knew our example property’s expenses could be cut by 25%, our profits would grow from $35,040 to $43,800. With that net profit number, the prevailing 10.7% cap rate would justify a purchase price of $409,346. However, the current expenses and net income tell us to not pay more than $327,477. If we get the property at that price and implement our management and expense improvements, we’ll be sitting on a nice value appreciation our first year. Plus, we’re generating a better NOI!
Cap rate can also help us to value our own properties for resale. We’re using it to take our net income and determine a selling price (divide the income by the prevailing cap rate of other similar sold properties). All of the factors apply, including perhaps working on our expenses first, raising our value, and then listing it for sale.
Cap rate, or capitalization rate, is a valuable tool used by real estate investors in a variety of ways. Learn how to use it to improve your multifamily and commercial property investment decisions.
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