Definition And Caveats
Let's start with a quick cap rate definition.
A cap rate or "capitalization rate" is used by investors to quantify
the relationship between an asset's net income and its value. It is
written as follows...
Cap Rate = Net Operating Income / Property Value
For example, if you are considering purchasing a piece of commercial
real estate with an "NOI" of $250,000 and the asking price was
$2,500,000, you could conclude based on those numbers that the cap rate
Cap Rate = $250,000 / $2,500,000
Cap Rate = .10 or 10%
Flipping Around The Cap Rate Definition
Alternatively, if you were considering purchasing an asset (say an
apartment building?) and you knew what the average cap rate of similar
apartments were, you could then attempt to derive a value for that
asset. Of course you would have to know what the NOI of the investment
property was as well. Using the same numbers as above, the value would
be determined as follows...
Property Value = NOI / Cap Rate
Property Value = $250,000 / .10
Property Value = $2,500,000
If you could purchase the property for less than that amount, you would
in theory be getting a good deal.
Keep in mind however, that you should only use the cap rate definition
/ formula above as part of a much larger analyzation process. You will
also want to scrutinize very closely any figures that you are using in
your calculations. In other words, don't take the NOI that the seller
presents to you as the gospel.
Always VERIFY, VERIFY, VERIFY!
Cap Rate Definition And Apples To Apples
Investors use cap rates in an attempt to simplify the relationship
between like assets for the purpose of comparison. The problem is that,
when it comes to real estate investment properties, no two are alike.
Therefore it is difficult to really compare apples to apples.
Cap rates certainly have their place in the due diligence process, but
beware not to put too much stock in this one tool!
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