How to Calculate Real Estate Cap Rates

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By eHow Contributing Writer

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Real estate investors often use the cap rate method as a means to value income-generating properties considered for potential acquisition. The method is relatively simple and offers a basic way to compare and contrast property values and income yields.

Difficulty: Easy

Instructions

Determine Purchase Price or Appraised Value

Step 1

Obtain an appraisal report for the target property. The appraised value will serve as the denominator of the cap rate equation. Alternatively, the most recent sales price of a comparable property can be used. For example, the recent sales price of a 100-unit apartment complex located on the same street can be used in lieu of the target property's appraised value, provided that the target property has similar characteristics.
Step 2

Determine the net operating income (NOI), or net rent, of the target property. This will serve as the numerator of the cap rate equation. This is calculated by taking total revenue (or effective gross rents) and subtracting operating expenses, taxes and insurance costs.
Step 3

Divide the net operating income by the appraised value (or comparable sales price). For example,
NOI = $2.0 million
Appraised value = $20 million
Cap rate = $2 million / $20 million = 10%

Tips & Warnings

The cap rate calculates the property's potential yield at a point in time. As a return indicator, the cap rate assumes that the property was acquired on an all-cash basis. Considering that most real estate transactions are done with some form of financing, it is important to adjust for leverage assumptions to calculate the investor's projected return. The NOI is the amount of income generated by the property's daily activities, prior to any capital investments and payments to debt holders. The recent economic climate has caused significant value adjustments to real estate properties. Therefore, while using comparable sales prices from six months ago was an accepted industry practice during times of economic stability, it is not the same story in 2009. In this case, using updated data is much more critical.

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