Using the Cap Rate

The Capitalization Rate is defined as CR=NOI/Price. Cap Rate is often used to valuate and compare investment opportunities. It is a simple way to do so. It takes into account expenses but not the financing, appreciation, tax impact, etc.

An Example:

There are 2 four-plex buildings.

Building A with an annual income (NOI) of $30,000, priced at $335,000 yielding a Cap Rate of  9%.

Building B has an annual income of $28,000, priced at $294,000 has a Cap Rate of 9.5%.

Just from the mathematical point of view, building B is a better investment. However, the investor likes building A and would like to get the same 9.5% cap rate, how much would he offer?

Solving the above equation for the price, P=NOI/CR, he would offer $315,700 (30,000/.095).

After purchasing the building A at his price, the investor spends time studying the operating expenses of the building. After a few short months of streamlining the operation, he reduces his expenses by $45 a unit per month for $2,160 a year therefore increasing his income by that amount.

Just by reducing expenses and streamlining his operation the value of his investment jumps by more than $22,000 in a few months.  $338,526=32,160/.095 (P=NOI/CR). Even at 10% Cap Rate, the value of his property would be well over what he paid for.

This example is only for illustration purpose.