Capitalization Rates or as they are affectionately known as Cap Rates, reveal the true value of an investment piece of real estate. These market rates of returns are a function of the general real estate market that you are buying into.
For example the exact same property located in a different area with the same net operating income can have a different rate of capitalization due to the location factor.
BY KNOWING COMPARABLE CAPITALIZATION RATES FOR A PROPERTY THE APPROPRIATE PURCHASE PRICE CAN BE ASCERTAINED
Cap Rates are just some of the real estate math discussions, for others please click here.
Cap Rates are an indication of the market demand for a particular commercial investment.
The lower the cap rate the higher the value of the property, and conversely the higher the capitalization interest rate the lower the value of the property. Therefore rates of capitalization have an inverse relationship to value.
This is because typically speaking a higher rate of return of an investment would yield a lower investment, or in the case of commercial real estate a corresponding lower sales price.
To perform any of the three cap rate calculations you would need to know two of the three variables.
1. Net Operating Income
2. Expected Market Rate of Return
3. Purchase Price of Property
Knowing any of the above two will yield the third.
Some examples are in order; let’s assume a building is for sale at $5,000,000, the net income for the building is $425,000, What is the Required Rate of Return of the investment?
(Calculation) $425,000 divided by $5,000,000 or 8.50 %
Now let’s assume that we know the investor want a market return of 8.50% what is the purchase price for a building with an NOI of $425,000?
(Calculation) $425,000 divided by 8.50% or $5,000,000.
Now let’s assume that we know the market rate of return we need, and we know the price we want to spend but we want to make sure that the property will cash flow according to our investment needs. What NOI do we need?
(Calculation) $5,000,000 multiplied by 8.50% or $425,000
Since the NOI of the property is constant, the variable for any project is the Cap Rate. A full understanding of the mathematical relationships of the three variables is absolutely necessary for the investor.