What is a CAP rate?
A CAP rate (Capitalization Rate), is the rate of return for real estate investment property which is derived from income the property produces.
The basic equation for explaining CAP rate is:
CAP rate = Net Operating Income (NOI) / Current Market Value (Sale Price)
As well, if you have a desired CAP rate you can use it to determine what price you wish to offer for a property. If you know what the Net Operating Income will be you may rearrange the equation above as follows:
Current Market Value (Sale Price) = Net Operating Income (NOI) / CAP rate
Net Operating Income
Net operating income (NOI) is determined by taking all annual income generated by an income-producing property after all income collected from operations is taken into account, and deducting all operational expenses.
Why is this important?
It is common practice to receive spreadsheets produced for properties outlining income and expenses that have certain expenses such as property management fees excluded or annual maintenance costs stated lower than average for a comparable property, which are often justified by the current owner performing these duties resulting in lower expenses and higher NOI. It is important to analyze all statements provided on a property thoroughly and to be able to highlight any anomalies and inconsistencies. In a case where a major expense is not reported accurately or if the operational expenses do not fall in line with how you or your purchaser will be operating the property, the NOI will be skewed and result in a perceived CAP rate which does not reflect the actual operations of the income producing property.