Capitalization rate, or cap rate, is often incorrectly used to determine a property’s, or real estate, value. Many people in the real estate industry (including sellers, lenders, and brokers) set a property’s price by using their method of determining the cap rate: Dividing the net operating income by the sales price.
An example of this is a property’s net operating income is $150,000 usd and the price is $1,150,000 usd. To find the cap rate, according to the common short-cut method of people in the real estate industry and by the majority of people over all:
$150,000/$1,150,000 = 13% capitalization rate
This is usually not a realistic or useful determination of a cap rate because it only considers that the property is paid in cash and this is only a one-year projection. How often do people buy a piece of real estate with cash? Not often. Often do you only need a one year projection and no more? Never. To determine the real cap rate, which is, obviously, more useful you must determine the cash-on-cash return which must add into the factor the amount of debt that will give us this leverage. (To determine this cash-on-cash return using debt leverage is not an easy method as you have to try, try, and try again). The debt is then subtracted from the net operating income and the true return will then be found. If any of the factors change then everything must be recalculated.
Yet this is more effective than the shortcut method of finding the cap rate and it is definitely more useful. It will give you the facts which in turn, will help you make better purchasing and investing real estate decisions.