Advantage Software LLC  How is the Cap Rate Calculated and Used?
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  The cap rate is a ratio that is used to estimate the value of income producing properties.  Put simply, it is the net operating income divided by the sales price or value of a property expressed as a percentage.  Investors, lenders and appraisers use it to estimate the purchase price for different types of  income producing properties.  A market capitalization rate is determined by evaluating the financial data of similar properties which have recently sold in a specific market place.  It provides a more reliable estimate of value than a market Gross Rent Multiplier since the calculation utilizes more of a property's financial detail. The GRM calculation only considers a property's selling price and gross rents.  The cap rate calculation incorporates a property's selling price, gross rents, non rental income, vacancy amount and operating expenses thus providing a more reliable estimate of market value.

If we have a seller and an interested buyer for particular piece of  income property, the seller is trying to get the highest price for the property or sell at the lowest cap rate possible.  The buyer is trying to purchase the property at the lowest price possible which translates into a higher capitalization rate.  In summary, from an investor's or buyer's perspective, higher is better.

Another way to visualize this important real estate ratio is via an example.  Letís assume you pay cash for an income property.  Since there is no loan on the property, net operating income will equal before tax cash flow.  Before tax cash flow is calculated by subtracting annual debt service which is equal to zero from the net operating income. When you pay cash for an income property, the capitalization rate will be equal to the cash-on-cash return.  The higher the capitalization rate, the higher the return on investment.  It can also be used as a measure of return on investment.

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The cap rate calculation does not include improvements such as the need for a new roof , new appliances, new carpeting, etc.  You should be aware of this when making purchase decisions.  The above necessary improvements will not be included in the calculation.  Be sure to inspect the property thoroughly.    

Investors expect a larger return when investing in high risk income properties.  Capitalization rates can vary in different areas of a city for many reasons such as desirability of location, level of crime and general condition of an area.  You would expect lower rates in newer or more desirable areas of a city and higher rates in less desirable areas to compensate for the added risk.  In a real estate market where net operating incomes are increasing and cap rates are declining over time for a given type of investment property such as office buildings, property values will be generally increasing.  If net operating incomes are decreasing and capitalization rates are increasing over time in a given market place, property values will be declining.

If you would like to find out what the capitalization rate is for a particular type of property in a given market place, check with an appraiser, commercial lender or a commercial real estate broker in that area.  Be aware that the frequency of sales for commercial income properties in a given market place may be low and reliable financial data may not be available.  If you are able to obtain a market capitalization rate from a commercial appraiser for the type of property you are evaluating, check to see if it was determined with recent sales of comparable properties or if it was constructed.  When adequate financial data is unavailable, appraisers may construct a cap rate through analysis of its component parts thus reducing the credibility of the results.  Evaluating the recent actions of buyers and sellers in a particular market place will produce the best market value estimate for a property. 

  If you are able to obtain a market capitalization rate, you can then use this information to estimate what similar income properties should sell for.  This will help you to gauge whether or not the asking price for a particular piece of property is over or under priced.   
                                                       NOI                                                                                  NOI
                      Cap Rate   =    ------------------                 Estimated Market Value   =     -------------- 
                                               Market Value                                                                     Cap Rate
                Example 1:   A property has a NOI of $126,000 and the asking price is $1,200,000.
                        Cap Rate   =       --------------         X      100     =    10.5
                Example 2:  A property has a NOI of $120,000 and Capitlalization Rates for this type of
                property average about 10.       
                     Estimated Market Value   =     --------------       =       $1,200,000
  Net operating income is determined by subtracting vacancy amount and operating expenses from a property's gross income.  Operating expenses include the following items: advertising, insurance, maintenance, property taxes, property management, repairs, supplies, utilities, etc.  Operating expenses do not include the following items; Improvements such as a new roof, personal property such as a lawn mower, mortgage payments, income and capital gains taxes, loan origination fees, etc.

Appraisers use the Income Approach, Cost Replacement and Market Comparison methods to estimate the value of property.  The Income Approach utilizes the theory of Capitalization.

The On Target Real Estate Investment Software calculates several important real estate ratios as you enter the property financial data.  You can run "what if" scenarios changing the sales price, rental income, vacancy rate and operating expense amounts and these ratios are automatically recalculated.  No need to use a calculator to run different scenarios.  The ratio analysis report summarizes the values of many important real estate investment ratios over a ten year period based on the data you input and the assumptions you make.

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