What Is an Income Capitalization Rate and How Do I Use it to Buy Investment Real Estate?

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Answered by: Solomon, An Expert in the Investing in Real Estate Category
Most individuals who are beginning to get involved in real estate investing learn about the income capitalization rate, frequently referred to as a "cap rate." For many of them, learning about the concept of buying property on the basis of capitalized income is an “a-ha moment.” After all, buying on a price per square foot, sales comparable, or other basis fails to answer what, for many investors, is the most important question: Will I make money on this property?

An income capitalization rate computes the percentage return on a property by comparing its Net Operating Income to its price. By dividing the NOI by the purchase price, one can calculate what the annual percentage return will be on the property. So, if an apartment building generates $96,000 in annual NOI and costs $1,200,000, it would present an 8% cap rate return. If the same building cost $1,300,000, the cap rate would be 7.38%, and if it was $1,100,000, the cap rate would be 8.73%. With this in mind, all other things being equal, buyers should focus on the investment with the highest cap rate to make the most money.

One nice thing about the cap rate is that it can also be used backwards. Given a cap rate and income, one can find a value. On the other hand, given a cap rate and a price, one can find what the NOI should be. Here are the equations:

Cap Rate = Purchase Price / NOI

     NOI = Purchase Price / Cap Rate

Purchase Price = NOI / Cap Rate

One tip to avoid getting confused is to remember that the Cap Rate is a percentage, and its value should be less than one. For example, an 8% cap rate is 0.08. Also, the NOI should be significantly less than the purchase price.

Although this looks like simple mathematics, actually using a cap rate is as much art as science. Given an apartment building in Chicago that generates $100,000 in NOI and costs $1,300,000, one can compute that the cap rate is 7.69%. However, does it make sense to buy or sell this building at this price? What if it was in Columbus, Georgia, or Coronado, California? Understanding if a cap rate is appropriate requires a strong sense of the market. It also requires an understanding of a property’s future prospects. If one is looking for future upside in income, it may make sense to pay a little bit more for today’s income to gain that potential. In other words, paying a 7.75% cap for a property which could produce the equivalent of a 10% cap in a few years can make more sense than paying an 8.25% cap for a property which would only go to an 8.5% cap in a few years.

The most important thing to remember is that investment real estate is, ultimately, about producing income. By paying attention to both individual property and market cap rates, one can not only avoid buying overpriced or selling underpriced deals, but also maximize income over the long term.

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