Many investors and appraisers use a CAP Rate (Capitalization Rate) to determine the value of investment property.
The CAP Rate the a percentage that relates the value of an income-producing property to is future income. It is calculated by determining the ration between the purchase price (Value) and the Net Operating Income (NOI) of the property. The formula being: CAP Rate = NOI / Value (purchase price), or R=I/V.
Example: A property has an NOI of $100,000, and the price is $1,000,000, the CAP rate would 10% ($100,000/$1,000,000). Based on this calculation, you would see a return in 10 years.
The benefit to using CAP Rate as a measurement of the value of property is that it is easily calculated and accounts for the operating expenses of the property. It can also allow the buyer – investor to compare and identify with comparable transactions and data sources within the market. However, once an investment property has perked the interest of a buyer by it’s CAP Rate, the buyer should further calculate the return on investment as well. This is known as Return on Cash or Cash-on-Cash. I will discuss this in a future blog
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