Beware Of The Apparent Simplicity Of The "Cap Rate" As A Tool For Measuring Value

Defining the Cap Rate (which is short for Capitalization Rate) of an income property in terms of a mathematical formula is quite straightforward. ie.

Cap Rate = Net Operating Income / Market Value X 100 and is expressed as a percentage value.

Conversely, if you want to determine the market value of a rental property, and you know what the market capitalization rate is, the formula would be as follows...

Market Value = NOI / Market Capitalization Rate X 100

What is not straight forward, however, is applying it in the 'real' world.

You have likely heard the phrase "garbage in, garbage out".

Expressed in a more diplomatic way this phrase simply means that if the data that you feed into an equation is flawed or incorrect, the results that you end up with will be similarly flawed or incorrect. As you will find out as you begin trying to use this valuation method to value apartment properties, "garbage in, garbage out" is very applicable. In order to overcome its flaws, you must have a strong understanding of its derivation, as well as a firm grasp on the data that is used.

One thing that many investors also fail to realize is that there is more than one way to "derive" or calculate the rate of capitalization. The formula above is typically applied when using the Direct Capitalization method. Another method that is used is referred to as the Overall Capitalization method.

It is important that you understand both methods, including how they are arrived at, and how they are used.

Sidebar: Keep in mind that there is no magic apartment capitalization rate that you (or anyone else) can derive that will tell you what an income property is worth. However, through a solid understanding and application of the overall capitalization method, you can determine a rate that reflects both your investment criteria, as well as a potential lenders criteria. A colleague of mine writes in more detail about this in his free email course on how to purchase your first apartment property . I believe the discussion on how to calculate a cap rate is contained in the first lesson. He also touches on the "Band Of Investment" method as well.

Now let's take a closer look at some of the issues you will face when utilizing this important apartment property valuation tool.

Just What Is Considered A Good Cap Rate When Purchasing An Apartment Building?

Understanding The Limitations Of Applying A Capitalization Rate To A Major Rehab Project

Return from Cap Rate to Apartment Building Real Estate Investment For The Rest Of Us home page