Investment Properties 101: Capitalization

Capitalization, also known as cap, is one of the most common methods to effectively estimate the value of an income producing property. This method is used by investors, lenders and appraisers for various kinds of income producing properties such as; apartment buildings, commercial spaces and multi unit family homes. Two main methods are used to calculate the capitalization rate: direct capitalization and yield capitalization. Direct capitalization uses income rate. This process of capitalization entails converting net overall income (NOI) into an indicator of a property’s current value. In general, any income flow could be capitalized but usually it is the NOI that is most commonly used.

To calculate accurately the capitalization rate, the variables needed are; property selling price, gross rent, non rental income, vacancy amount and operating expenses. The overall capitalization rate is the most widely used direct capitalization method. It is based on market research using the NOI and the sale price of comparable properties. Capitalization rates determined by carefully evaluating the recent actions of buyers and sellers in a particular marketplace will produce the best market estimate for a property. This formulation demonstrates the relationship between net operating income for one year and the value of the property. Furthermore, direct capitalization is exceedingly dependant on the cap rate selection.

Cap Rate Formulas

a)Estimate Value = Income divided by Rate
b) Estimate Capitalization Rate =  Income divided by Value

c)
Estimate net operating income = value multiplied by rate

For example, if a person would like to sell their property, he or she would want to sell for the highest selling price possible, while having the lowest cap rate possible. If a person would like to invest in a property, he or she would be searching for the lowest purchase price possible with the highest possible cap rate while maintaining quality. In summary, the lower the price of the property while maintaining the same level of Net Income, the higher the cap rate will be. A higher cap rate translates to a more profitable property.

However there are some cautionary points that should be addressed when using cap rate calculations. Cap rate calculations only include operational expenses, which do not include capital improvements. Take note, deferred maintenance (what the previous owner should have fixed but did not) and potential appreciation of the property would not be included in the calculations. It is important to not solely base your investment decision on capitalization rates alone, a thorough inspection of the property should be completed as well.