Calculating capitalization rates, commonly referred to as the cap rate in the real estate industry, is the easiest way to find the value of an income producing property. To calculate the cap rate you will need two numbers from the subject property; first, its net operating income, or NOI, and second its listing or purchase price.
Let's go over the math behind the calculations first, then I will provide a step by step example for you to follow along.
To find the net operating income, first add together the gross annual income less vacancies. This number is the gross effective income. Next, subtract all of the property's annual operational expenses not including the mortgage payment. The gross effective income minus operating expenses equals the net operating income.
The second step is to find the subject property's listing price or you can use the agreed upon purchase price. Divide the net operating income by the price of the property to find the cap rate.
Now on to our sample case. We will use an example of a property with $100,000 of gross annual income and a 10% vacancy expense. This leaves $90,000 for gross effective income. Annual operating expenses total $30,000. Subtracting expenses from the gross effective income equals $60,000 in net operating income. If this property was listed for $1,000,000 we would divide the NOI by listing price to get a 6% cap rate.
Gross Rental Income - Vacancy Expenses
= Gross Effective Income
- Operational Expenses
= Net Operating Income
/ Property Price
= Capitalization Rate