By: Nathan Metheny, Managing Principal/Co-Founder
Capitalization Rate (Cap Rate)- Capitalization rate is a real estate valuation metric used to value a real estate asset. The cap rate can be found by dividing the Net Operating Income by the purchase price or fair market value.
Cap Rate = NOI/Purchase Price
Inversely, the fair market value or purchase price can be determined by dividing Net Operating Income by the Cap Rate percentage.
Value = NOI/Cap Rate
Although cap rates are the standard in determining an asset’s value, there are gaps that an investor should fill rather than relying solely on the cap rate metric.
Cap Rates are Dependent on Net Operating Income (NOI)
NOI is the major influencer when using a cap rate to find the value of an asset. An issue arises when different methods of calculating the NOI are used. The past 12 months financial statements are the most common method to determine the NOI; however, it is not uncommon for investors to use projections. Different investors operate properties differently; lowering expenses, increasing rents, or anticipating lower property taxes. The value can be drastically different with the different methods used. At a 6% cap rate, a $30,000 difference in NOI would adjust the value of the subject property by $500,000.
Cap Rates Disregard Debt Service Payments (Mortgage)
As previously stated, cap rates are fully dependent on NOI, which does not include your monthly mortgage payments. Many investors plan to leverage their asset with debt financing. As most debt can reach as high as 75-85% of the asset value, it limits the usefulness of the cap rate metric for potential evaluations.
Cap Rates Don’t Reflect Future Income
Cap rates are used synergistically with the previous 12 months NOI. With the set time period, it is difficult for cap rates to predict future value. One of the major factors to consider is fluctuating rents/expenses. The limited viewpoint on the property’s financials impairs an investors evaluation because it is impossible to determine if the property is improving or declining.
With the help of Wealthrise, you can make use of these insights into capitalization rates. Sign up for our monthly newsletter to learn more about the benefits of real estate investing and the many ways that you can get involved.
About the Author: Nathan Metheny is Co-Founder and Managing Principal at Wealthrise. In this capacity, his primary roles include acquisition supervision as well as setting the long-term strategy and trajectory for the company.