A Cap Rate or Capitalization rate is one of the basics real estate valuation.  This is a direct income approach: value equals net operating income divided by cap rate. You’ll see the Cap rate as a base of analysis in most real estate marketing materials and market trends discussions.

The capitalization rate is a very simple measure made up of 3 components.  The Cap Rate, NOI or Net Operating Income and Value.  Knowing any two will help you figure out the third. 

If you want to determine the cap rate of a property first look at the NOI.  The Net Operating Income (NOI) does not include things like debt service, depreciation and capital expenditures; it simply reflects the buildings capacity to earn income. 

Cap Rate = (NOI divided by market value)   or the cap rate for a fourplex priced at $330,000 with an NOI of $26,500 is 8.03  ( .0803 (8.03%) = ($26,500/$330,000)

If you do some research in the market and find that for a certain type of property the current market cap rate is 7.25% then you can determine what the value of the property is.

($26,500/.0725  = $365,517)

What the current cap rates are in a given market is very diverse, depending on location, property type and property class.  Just as with any other measure the more precise you get the better the results will be.  You can look at a Greater Phoenix cap rate but you would be safer looking at individual sub-markets.  It’s not always ease.  In fact it’s never easy to be very precise about current cap rates but its certain to say that currently they are on the rise.  Meaning that prices are decreasing as a result of investor demands for increased cash flow as a hedge against risk.

The Cap rate is a good way to quickly and simply monitor the market and establish the viability of potential real estate property; it’s a measure to quickly include or eliminate potential properties to buy, establish a value for selling a property or foretelling the market trends.  It should not be used for more then a stepping stone to a more detailed feasibility study.

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