# Income Property Valuation Using Capitalization Rates

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Serving your real estate investor clients, you'll need to be able to aid them in the valuation of income properties. A common method used, among others, is the capitalization rate, or "cap rate." Once your client has an income property under consideration, you can help them to see if the asking price is justified by using the current cap rate for comparable properties and the net income this property generates.

### Key Takeaways

• Cap rate is one way real estate investors can determine the value of a property they're interested in buying.
• You can calculate cap rate by dividing a property's net operating income by its listing price or market value.
• Cap rate is just one of many valuation tools you can use to determine if a property is worth its purchase price.

## What Is Cap Rate?

Capitalization rate, "or cap rate," is a calculation tool used to value real estate—mostly commercial and multi-family properties. Cap rate is the net operating income (NOI) of the property divided by the current market value or purchase price. NOI equals all revenue from the property minus all necessary operating expenses.

## Determine Property Income That Justifies the Asking Price

If your client knows the asking price of a property and the current cap rate for similar properties, you can calculate the net rental incomes necessary to justify the asking price.

For example, if a property sold for \$1,000,000 and the total revenue after expenses or NOI was \$150,000, the cap rate would be 15% (150,000/1,000,000 = .15, or 15%).

What if other properties in the neighborhood also sold for a similar amount but only yielded \$100,000 in NOI? The cap rate for those properties would be 10%. A lower cap rate in this example could be the result of a lower NOI due to higher operating expenses (leading to a lower profit from the investment) or lower revenue earned on the properties.

### Note

By analyzing the cap rate and the net operating income earned on properties in the area, you can get a sense of what the potential return will be on the property you're looking to buy. From there, you can determine if the asking price is too high or not.

## Other Calculations to Value a Real Estate Investment

Part of your value as a real estate agent or broker is to assist them in determining the true value of a property. Using the capitalization rate is one of several valuation tools that can provide your clients a good understanding of what a property is worth.

### Net Operating Income

Net operating income is the net result of revenue from the property minus operating expenses. However, NOI is calculated before taxes and doesn't include principal and interest payments on any loans.

### Net Rental Yield

The rental yield is similar to NOI but takes into account taxes. You can calculate the monthly rental income minus monthly expenses and tax payments. From there, you divide that figure by the market value price to get net rental yield. It's important to include repair costs and upkeep as well.

### Gross Rent Multiplier

Gross rent multiplier (GRM) is calculated by dividing the market value of the property by the annual gross income. The GRM figure gives you an approximate return on a property without factoring in expenses. The GRM is easy to calculate but isn't a very precise tool for ascertaining value.

### Cash Flow of a Rental Property

Cash flow analysis is helpful in determining how much monthly income (or cash) is left over after repair costs, expenses, and a vacancy rate. Properties might sit idle for a few months and vacancy should be factored into the analysis. Cash flow analysis is helpful in providing the monthly income to earn back your initial cash outlay for the down payment or any repairs.

### Gross Scheduled Income and Effective Gross Income

Gross scheduled income (GSI) helps you know what income will be realized if a property is fully occupied and all rents are collected. Take the number of units times annual rent for GSI. Once you know the GSI of a real estate investment property, we arrive at the effective gross income by subtracting out the estimated annual losses due to non-payment or vacancies.

### Depreciation of a Rental Property

You can calculate the depreciation of a building by deducting out the value of the land and dividing the building value by 27.5 years for annual depreciation. For example, a building is valued at \$245,000, so we divide \$245,000 by 27.5 years, which equals \$8,909 in annual depreciation.

### Note

Depreciation can be used as a tax deduction.

### Breakeven Ratio for Rental Property

Lenders use the break-even ratio as one of their analysis methods when considering providing financing for a real estate investment property. The breakeven ratio factors income gross rental income, total debt payments, and all operating expenses. Too high of a break-even ratio is a cautionary indicator.

## Do you want a high cape rate or low cap rate?

In general, a higher cap rate indicates could indicate more risk. Cap rates are similar to the bond market. A bond with low rates is a safer investment than a bond with high rates.

## How do you calculate building value with cap rate?

To calculate cap rate, you divide a property's net operating income by its listing price or market value.

Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
1. Anderson Business Advisors. "How to Calculate Cap Rates for Rental Real Estate."

2. PropertyClub. "Net Operating Income Guide."

3. Los Angeles Community College District. "California Real Estate Principles, 10.1e—PowerPoint—Ch 10.ppt," Slide 20.

4. Trion Properties. "What Is Gross Scheduled Income?"

5. AssetsAmerica. "Potential Gross Income."

6. IRS. "Publication 527 (2020), Residential Rental Property." Click "Recovery Periods Under GDS."

7. First National Realty Partners. "What is Breakeven Occupancy in Commercial Real Estate?"

8. Roofstock. "Is a Higher Cap Rate Better? Understanding Risk/Reward."

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