Posted by Rolfe Kurtyka (Mpls/StP) on November 10, 2001 at 21:01:26:

Capitalization rates relate a property’s income to the property’s value.

If we know a property’s income and what the property sold for, we can determine the cap rate. When enough deals are known, an overall cap rate for that type of property begins to hover around a consistent number. That’s the cap rate for that type of property in that general location.

Here’s the formula;

V = I/R

Value = Net operating income divided by the cap rate.

R = I/V

Cap rate = Net Operating Income divided by value.

I = R x V

NOI = Cap rate times Value

In a round about way, one way to consider a cap rate is as a measure of return. A higher cap rate means the property generates more income per dollar of value (R = I/V)

You can use a cap rate to compare different investment opportunities. Properties which produce a certain income sell for a certain price, and a cap rate can be determined (R = I/V). Similar buildings in the area will likely show similar cap rates. If a similar building shows up on the market at a higher cap rate, that might be a deal.

You may decide to only buy buildings which meet a certain cap rate. Once you determine the property’s net income, you divide that by your cap rate. That’s the price you’re willing to offer.

Hope this helps. You might try the commercial board at this site.

Rolfe