![]() Multiply by 100 to Convert from Decimal Notation to Percentage Form.Divide the Property’s Annual NOI by its Current Market Value.Determine the Market Value of the Property as of the Present Date.Calculate the Net Operating Income (NOI) of the Property at Stabilization.The step-by-step process to calculate the cap rate is as follows. The NOI used to analyze the capitalization rate of rental properties must be stabilized to reflect their “steady-state” performance, wherein the operations of the properties are functional and starting to generate rental income. The fair value is determined in an independent appraisal and is intended to reflect the current value of the property rather than the original purchase price. Property Value → The current market value, on the other hand, is the property’s fair market value (FMV) as of the present date.Net Operating Income (NOI) → The net operating income, or “NOI,” represents the income potential of a property based on its core drivers of revenue, such as rent payments, minus its operating expenses, e.g., maintenance costs, property taxes, and insurance.The net operating income (NOI) and property value are the two inputs in the cap rate formula: The cap rate is calculated by dividing the net operating income (NOI) of a rental investment property by the market value of the property as of the present date. Stabilization refers to the state at which a real estate development project or acquisition is near complete, and the property is close to fully functional, with the rental units of the property leased near full occupancy with rent prices close to the market rate.īy converting the NOI of a property into a percentage, the cap rate is a standardized metric that facilitates “apples-to-apples” comparisons between comparable properties to identify the investment opportunities that offer attractive risk-return trade-offs. The NOI of the properties must be expressed on a pro forma basis to reflect the income that the properties expect to generate at stabilization. The commercial real estate (CRE) market participants must closely weigh the risk-return profiles of potential investments to determine the purchase price at which the target yield is attainable to guide their investment decision-making process.Ĭap rates are the primary shorthand by which different properties with comparable risk-return profiles can be analyzed side-by-side.Ĭap rates in real estate estimate the rate of return on rental properties based on their perceived income potential. The cap rate, an abbreviation for “capitalization rate,” is a real estate metric that reflects the expected rate of return on rental property investments. There is no good cap rate, per se, because the decision is subjective and contingent on the specific investor’s risk-return profile, but most commercial real estate investors target a cap rate between 4% to 10%.The higher the cap rate, the higher the risk and potential return – all else being equal.The cap rate is frequently used among real estate practitioners to compare different investment opportunities to determine the property with the most attractive risk-return profile.The cap rate formula divides the net operating income (NOI) of a rental property at stabilization by the market value of the property as of the present date. ![]() The cap rate is defined as the potential rate of return on a rental property building, such as a commercial real estate investment.
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