Property investors, real estate appraisers and commercial real estate investors use capitalization rates (cap rates) to ascertain the worth of commercial real estate. Lenders and investors prefer higher cap rate to lower ones. They vary from location, property condition and marketplace trends. A prudent investor decides a property’s worth based on his preferred cap rate; acceptable rates vary with an individual investor’s tastes. The formula for a building’s cap rate is net operating income divided by sales price.
Determine gross earnings by incorporating all of the property’s rents and other income, such as money from a laundry area. Assume, by way of example, a building with a total annual income of $200,000.
Subtract income lost because of vacancies from gross income to yield effective gross income. Successful gross income is income before maintenance, advertising, management and other operating expenses are compensated. Assume income lost due to vacancy is $40,000. Gross income ($200,000) minus vacancy loss ($40,000) equals effective gross income of $160,000.
Subtract operating expenses (assume $70,000) from effective gross income ($160,000) to find net operating income of $90,000.
Divide net operating income ($90,000) by sales price (assume $600,000) to yield a cap rate of 15 percent (0.15). Divide net operating income (90,000) by your preferred cap rate (assume 12 percent) to ascertain the right sales price ($750,000 in this case ) if the sales price is unknown.