Crystal Harris - Realty Executives - Capitalization Rates Tucson

The Capitalization Rate represents the projected annual return from an investment property. The Cap Rate directly links the value (sales price of the home) to the income produced by the property before mortgage payments and income taxes.

Lenders, appraisers and investors all use the Cap Rate to estimate the purchase price for different types of income producing properties.

Step 1: Find the Net Operating Income (NOI). It is critical to verify existing income before establishing value.

Expenses include: Advertising, property management, necessary repairs, supplies, utilities, vacancy amount, etc. Expenses don't include: Home Improvements, personal property, mortgage payments, income taxes, loan origination, capital gains, etc.

Example: Let's say the gross annual income of a commercial property is $36,000 and the total operating expenses is $10,000. The appraiser estimates the value ot the income property to be $240,000. The Net Operating Income (NOI) = Gross Annual Income - Expenses would be; $36,000 - $10,000 = $26,000. The Cap Rate = $26,000 / $240,000, therefore the Cap Rate = 0.11 = 11%.

Cap Rates vary depending on risk areas, estimate of property value, income stream and the accuracy from investigating these components.

Purchasing an income property at an 11% Cap Rate means that the investor is hoping for an 11% annual return from their investment. Cap Rates generally fall between 7-10%.

A higher Cap Rate means the income property has less value with an increase in the amount of risk, so an investor would expect a greater annual return to compensate for that risk. Buying a newer income property in an upscale neighborhood with no major repairs or improvements to make will likely have a lower Cap Rate with more value than a older income property located in a run-down neighborhood.

An investor will also use a Cap Rate to determine value (purchase price) for an income property. NOI / Cap Rate = Max. Purchase Price. Example: If an income property produces $40,000 in income and you want to realize a 10% return on your investment, you would figure on buying it for approximately $400,000. Even if the income property is listed at 10-15% above the purchase price calculation ($40,000 - $60,000 more), many investors will still want to take a look at the property and consider making an offer to purchase.

Remember that Capitalization Rates are not a 100% guarantee on accuracy. Performing due diligence in figuring value (most recent comparables), property income verification and net operating expenses will help mitigate the risk when using Cap Rates to help determine which income properties to make an offer on to purchase.