The Capitalization Rate:
The Cap Rate is calculated as follows:
Cap Rate = (Net Operating Income / Market Value) x 100
Cap Rate = (NOI / MV) x 100
Net Operating Income (NOI): $239,430
Market Value (MV): $3,420,000
Cap Rate = (239,430 / $3,420,000) x 100
Cap Rate = 7%
The Cap Rate of 7% represents the annual return before mortgage payments and income taxes on the total investment of $3,420,000.
Alternatively, if the Cap Rate can be established from comparables, we can determine the likely selling price of a property. For example, if the cap rate is 7.5 % based on comparables, and the Net Operating Income (NOI) for the building is $105,000 , the potential selling price can be calculated as follows:
MV = (NOI / Cap Rate) x 100
MV = (105,000 / 7.5) x 100
MV = $ 1,400,000
The Net Income Multiplier (NIM)
The Net Income Multiplier (NIM) is the inverse of the Cap Rate
NIM = 100 / Cap Rate
or Cap Rate = 100 / NIM
As an example, if the NIM is 11, the Cap Rate is:
Cap Rate = 100 / NIMCap Rate = 100 / 11 Cap Rate = 9.09%
Both the Cap Rate and its counterpart the Net Income Multiplier are used in the real estate industry to estimate the market value of a property. However, in recent times, the Cap Rate has become the more popular financial measure. Regardless of which measure is used; they both produce the same estimate of market value.
The Net Income Multiplier is expressed as follows:
Net Income Multiplier (NIM) = Market Value / Net Operating Income
i.e. NIM = MV / NOI
Net Operating Income: $239,430
Market Value (MV): $3,420,000
NIM = MV / NOI
NIM = 3,420,000 / 239,430
Alternatively, if the Net Income Multiplier can be established from comparables, we can determine the likely selling price of a property. For example, if the Net Income Multiplier is 7.0 based on several comparables, and the Net Operating Income for the building is $180,000 , the potential selling price can be calculated as follows:
MV = NOI x NIM
MV = $180,000 x 7
MV = $1,260,000.
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In real estate appraisal, capitalization is the process of converting income, in the case of real estate net rental income, to a property value. The capitalization rate or CAP Rate for short, is the ratio of yearly net income to the property value. For example, if you purchase an investment property for $120,000 dollars and can generate $1,000 per month after all operating expenses (before debt service), then the CAP Rate would be $12,000 divided by $120,000 or 10 percent. This means it will take approximately 10 years to recoup the property value in net rental income assuming the rent stays the same.
In general, the lower the CAP Rate the better if you are selling and the higher the CAP Rate the better if you are buying. However, make sure the neighborhood is good and the property is in decent condition. CAP Rate does not help if the property is declining in value.