Real Estate Investment Terminology

Many of the terms we will be discussing are often poorly understood and can even be misleading if not taken in context and applied correctly to the specific investment at hand.  For this installment we will be focusing on the term capitalization rate or “CAP Rate”.   

Let us calculate the Net Operating Income and Capitalization Rate on a four unit apartment building.  Each of the apartments rents for between $1200 and $1350, the owner pays for property management services, a gardener to keep up landscaping and provides coin operated laundry machines for the tenants to use.

Annual Income   Annual Expenses
Apartment One $14,400.00 Property Tax $5,000.04
Apartment Two $15,300.00 Property Management $4,410.00
Apartment Three $16,200.00 Gardner $720.00
Apartment Four $15,600.00 Laundry Machine $480.00
Laundry Income $1,500.00 Insurance $1,392.00
Total Income $63,000.00 Total Expenses $12,002.04

Total Income Less Total Expenses=Net Operating Income
$63,000 Income Minus $12,002.04 Expenses = $50,997.96 Net Operating Income

Now that we have the Net Operating Income we can calculate the Capitalization Rate or ‘CAP Rate”. The CAP Rate is simply the income produced relative to a sale price.  Assume our sample property above is offered for sale at $450,000.

Net Operating Income $50,997.96 / Offered forSale$450,000.00 = 11.3% Capitalization Rate

Now, let’s say the offering price is now $650,000 instead of $450,000.  What is our new Cap Rate?

Net Operating Income $50,997.96 / Offered forSale$650,000.00 = 7.85% Capitalization Rate

It is imperative to remember that while the Capitalization Rate or “CAP Rate” is an effective tool that is helpful it is not the do all/end all means of evaluating an investment.  The Capitalization Rate or “CAP Rate” is only a snapshot in time-revenues and expenses can increase (or decrease) and any new owner should accurately calculate the expenses after acquisition as they may likely be paying significantly higher property taxes than the seller dependent upon how much the seller acquired the property for.  It also excludes any extraneous attributes such as a prestigious location, historical significance or potential for future appreciation due to development plans for nearby properties the property may have that would make it either more or less valuable to a potential investor.