In this post, I’ll be doing a quick write up on market capitalization (cap) rates. Market cap rates are different from derived cap rates, which I explored in a previous post.
Market cap rates are the rates more commonly referenced, and they are powerful because they don’t take the current financing landscape or an individual investors financial situation into account. Market cap rates give you an idea of the possible rate of return you might expect from this investment. The formula for cap rate is as follows:
CAP RATE = Net Operating Income / Value
In today’s internet age, a market’s cap rate is widely available, but it’s important to remember the variation from area to area. When of the variables for cap rate, after all, is the value of a property. That value means the recent sale price of given properties. So why is this important to us as investors? Let’s assume you didn’t have the internet or the convenience of a market research agency. It’s still not that hard.
You are attempting to evaluate a duplex in your area and determine it’s value. Remember, income properties are valued based on their cash flow (more on that in future posts). Here some simple steps to follow in determining it’s value.
- Compile a list of comparable duplexes in the immediate area and compute an average sale price (i.e. value).
- Perform detailed analysis of the income and expenses associated with the property in question. Don’t assume the numbers you’re given are correct. Trust but verify! The resulting number from this process will be your Net Operating Income (NOI).
- As a variation of the cap rate formula, find the computed value of the property by dividing the annual NOI by the market cap rate. Is the resulting figure higher or lower than asking?
There is a lot that goes into property analysis, but here’s a quick snapshot of one of those processes! Look for more in the future as we delve deeper into these topics.