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What's a cap rate anyhow?

by Ozzie  Jurock

Saturday, March 29, 2014

One of the most difficult and perplexing problems for realtors and investors is finding current Gross and Net Income Multipliers and Cap Rates. Determining the value of an income property generally involves establishing either the Gross or Net Income Multipliers, or the Cap Rate according to comparables.

There are a number of difficulties:

The Net Operating Income is probably the most widely used indicator of the building's financial performance, and is frequently used in determining the value of the property. The Net Operating Income is the cash remaining after deducting the Operating Expenses from the Effective Gross Income (EGI). There are several items, which often appear on financial statements, which must be deleted before calculating the Net Operating Income (NOI).

  1. Debt Service, i.e., principal and interest payments are ignored because the Net Operating Income reflects the earning capacity of the property exclusive of financing.

  2. Depreciation allowances or any other purely bookkeeping or Income Tax deductions are ignored.

  3. Capital Expenditures which provides long term benefits such as replacing appliances, painting of the building etc. are omitted.

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

Example:
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 / NIM
Cap 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
Example:
Net Operating Income: $239,430
Market Value (MV): $3,420,000
NIM = MV / NOI
NIM = 3,420,000 / 239,430
= 14.28

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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About the Writer:
Ozzie Jurock is the president of Jurock Publishing Ltd., Editor of Real Estate Insider Publication and Author of Forget About Location, Location, Location



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