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Cap Rate Determines Value (of an Income Producing Property)

by  | Corporate
Posted:     Updated: Oct 19, 2017  1:06 ET
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The Capitalization Rate or Cap Rate is a ratio used to estimate the value of income producing properties. Put simply, the cap rate is the net operating income divided by the sales price or value of a property expressed as a percentage. Investors, lenders and appraisers use the cap rate to estimate the purchase price for different types of income producing properties. A market cap rate is determined by evaluating the financial data of similar properties-recently sold in a specific market. Since the cap rate calculation utilizes more of a property's financial detail, this cap rate provides a more reliable estimate of value than a market Gross Rent Multiplier (GRM). 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, this calculation provides a more reliable estimate of value. For instance, if a market cap rate is available, one may use this information to estimate what similar income properties should sell for. This determines whether an asking price (for a property) is over or under priced. As in the following examples:

Net Operating Income (NOI)

Cap Rate = Estimated Market Value = Market Value Cap Rate Example 1: A property has a NOI of $155,000 and the asking price is $1,200,000. $155,000/$1, 200, 00 = 12.9% Cap Rate

Example 2: A property has a NOI of $120,000 and Cap Rates in the area for this type of property average about 12%. $120,000 x .12 = Fair Market Value of $1,000,000

Still, the following reflects the inverse relationship of price and cap rate: a) If we have a seller and an interested buyer, the seller is trying to get the highest price for the property or sell at the lowest cap rate possible; b) The buyer is trying to purchase the property at the lowest price possible-translating into a higher cap rate. Invariably, the lower the selling price the higher the cap rate. A higher selling price equates to a lower the cap rate.

In summary, from an investor or buyer's perspective, the higher the cap rate, the better. Investors expect a larger return when investing in high-risk income properties. The Cap Rate may vary in different areas of a city for many reasons such as desirability of location, level of crime and general condition of an area. Investors should expect lower capitalization rates in newer or more desirable areas of a city and higher cap rates in less desirable areas (compensating for the added risk). In a real estate market where net operating incomes are increasing and cap rates are declining, values generally increase. If net operating incomes are decreasing and capitalization rates are increasing, property values are in decline.

For conversation and value-added service, contact: 216-373-7539 or forward an inquiry or lending scenario

Topics: Commercial hard money | Commercial lending
More by: LUCEV Finance & Investment Group


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Cap Rate Determines Value (of an Income Producing Property)

by LUCEV Finance & Investment Group | Corporate
Posted: Aug 11, 2017  16:47 ET    Updated: Oct 19, 2017  1:06 ET

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