The definition of a capitalization rate is: The net operating income divided by the property value. A percentage representing the return on the investment, assuming the property was purchased for cash. So to determine the cap rate you must know the property value and the net operating income. To determine the property value you will need to do some research. Find at least three similar properties that have sold in the past year. Comparing them to the subject property, find the differences. There are values for location, size, functionality, condition, age and use. The values will be different depending on the market conditions where the property is located. You can get these values from a local appraiser of you can average the three "most comparable" properties and come up with a approximate value.
Instructions
1. Once you have determined the approximate value, you will need to determine the net operating income on the comparable properties. Net operating income is determined by deducting operating expenses from effective gross income. To find the effective gross income is potential gross income minus vacancy and collection losses plus other income. Simply, If you have an apartment building that has 20 apartments and each apartment is rented for $400 monthly, your potential gross income is $8000 per month or $96,000 per year. However, not all the apartments are rented all the time. Let's say you have a vacancy rate of 10%. 10% of 20 apartments is 2 apartments. This means 18 apartments are rented all the time. So you deduct $9,600 from the $96,000 and get $86,400. No suppose you have vending machines, washers and dryers that net you another $5,000 per year. Your effective gross income would be $91,400.
2. From your effective gross income you will deduct your net operating expenses. To find the properties operating expenses you need to look at three categories: fixed expenses, variable expenses and reserves for replacement. Fixed expenses would include property taxes and insurance. Variable expenses include utilities, supplies, management, maintenance, cleaning services and trash removal. Reserves for replacements is a fund for things such as replacing a roof or painting the exterior of the building. You need to estimate the cost of the job and divide by the life of the repair. This is often left out of the operating expenses so if you can't find it in the financial statement estimated it yourself. This could be a very substantial expense at some time.
3. Now that you have determined the operating expenses, deduct them from the effective gross income that you calculated earlier. This will give you the net operating income. Divide your net operating income by the value of the property and you have determined the capitalization rate. If it is below the standard rate at the time, this is not a good investment if you are looking for a certain return on your money. You can however determine what rate you desire, divide the net operating income by your desired rate and determine what you would be willing to pay for the subject property and then make an offer to the owner. The worst that could happen is that the owner rejects your offer and you move on to the next property.
