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Cap Rate Analysis Income Approach to Valuation Cheat Sheet (DRAFT) by [deleted]

Cap Rate Analysis Income Approach to Valuation

This is a draft cheat sheet. It is a work in progress and is not finished yet.


The cap rate is used as a way to value income producing commercial proper­ties. It is one of several consid­era­tions to be used when evaluating property.

The term "cap rate", short for capita­liz­ation rate, can be thought of as a "rate of return­" or "­int­erest rate". In other words, what rate of return or interest does the investor want to produce on their invest­ment?

Different invest­ments yield different rates, depending on risk. For instance, by putting money in the bank, it is expected to have a low rate of return, due to the fact that it is a less risky invest­ment. With real estate invest­ments, it is a high risk invest­ment, therefore, a prudent investor expects a higher rate of return or cap rate.

The rate of return in real estate invest­ments fluctu­ates, depending on current market condit­ions.

A formula is used to determine cap rate, by taking income minus expenses and turning them into a ratio which shows the amount of return on investment (cap rate) to estimate the value of the income producing property.

Steps to determine Cap Rate:

1. Determine the amount of gross income the property can produce.

2. Subtract an estimate for vacancies.

3. Subtract estimate for collection losses.

4. The result is the effective gross income.

5. Subtract the operating expenses, including fixed expenses such as taxes, insurance, management fees, mainte­nance, utilities, etc.)

6. The result is the Net Operating Income (NOI).

7. Divide the NOI at a the current capita­liz­ation rate. (Your local commercial real estate profes­sional will be able to tell you what current market cap rates are).

CAP Rate Analysis

Basic Capita­liz­ation Formula

The basic capita­liz­ation formula in the income approach looks like this: Value, Rate of Capita­liz­ation, and Income. Below is the formula:

V = I divided by R; or
V = I/R
Cap rate is not the only factor to consider in determ­ining value. Analysis should take into consid­eration all factors contri­buting to the value of a particular property