Capitalization Rate is a formula used in real estate to measure the rate of return for an investment at any given time. The capitalization rate (CAP rate) indicates the ratio of an asset’s net operating income to its purchase price. It’s important to note, the cap rate formula does not include any mortgage expenses.

In order to arrive to your net operating income you subtract your vacancy factor, property taxes, property insurance, maintenance/repairs, utilities, and other expenses from your gross rental income. Once you have arrived at a figure for your NOI, you divide that number by the purchase price or market value – depending on whether the investment asset has been sold or not. Arriving at a CAP rate can get a bit tricky though…and I’ll explain below.

Not All CAP Rates are Created Equally

RE agents/brokers, banks, appraisers, and owners may use a different variation when it comes to expenses for an investment property. Let’s give an example – multifamily. An owner has operated a building for the last five years and is looking to sell the property. The owner mentions to us that he/she hasn’t had vacancies in his/her rental units since owning the building and thus should not include any vacancy percentage in our expenses. However, on the sale of the property, a lender underwrites the property with a 3%-5% vacancy factor – depending on the location of the property.

As a result of using underwriting assumptions such as 3%-5% vacancy, the banks capitalization rate is lower than that of the owner who has not had any tenant move out since purchasing the building. How do you agree at that time on a uniform CAP rate?

In order to resolve this problem, we have our clients use baseline expense figures that are more aggressive than what it normally costs to run an investment asset. That way you build into your assumptions a broken pipe, buying a new water heater, or a reasonable vacancy factor – which are events that occur out of the blue and affect your net operating income.

In conclusion, a capitalization rate is a good financial indicator for the rate of return of a real estate investment property if you buy it all-cash. However, make sure to consider that investors and real estate professionals will have a different opinion about expenses depending on the location and product type. Just to make sure to side on the err of caution.