Capitalization Rate

Photo Credit: richkidsuniteAs a rule of thumb, the lower the capitalization (CAP) rate, the more expensive the property as it relates to its net operating income (NOI). The higher CAP rate, the less expensive the property as it relates to its NOI and therefore, the higher the return on investment. Absent other variables, higher CAP rate investments are more lucrative than lower CAP rate investments.

The following example shows how to determine the CAP rate of any property:

Tom has four units for sale. The purchase price is $225,000. Tom discloses that all units are rented for $795 each per month. Tom also discloses that the property has a vacancy rate of 5% (V&C) and that the property’s operating expenses (OE) are about 28% of the gross income (GSI). What is the CAP rate?

Start by determining the Net Operating Income of the property (NOI). Net operating income is:

Gross income – less vacancy and credits – less operating expenses = NOI

  1. Rents of $795 X 4 units X 12 months = $38,160 gross scheduled income (GSI).
  2. $38,160 less $1,908 for Vacancy and Credit = $36,252 gross operating income (GOI).
  3. 28% operating expenses (OE) of gross income = $10,685 operating expenses.
  4. Deduct the operating expenses of $10,685 from $36,252 = $25,567 NOI.
  5. With NOI being $25,567, divide it by $225,000 purchase price = 11.36% CAP rate.

Photo Credit: rickidsunite

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