How to Determine Rental Property Value with a Cap Rate

Using the cap rate approach to arrive at a property’s market value can be used for any rental income property. Including, multi-family units, office buildings, warehouses, retail strip malls, or similar properties that generate rental income.

This is particularly helpful when you want to arrive at a rough listing or resale price quickly and easily. When you might want to suggest a price for a particular rental property based on the market cap rate or a customer’s desired capitalization rate, for example.

In this article, we’ll use a mock situation and walk you through the process. Let’s assume that you were asked by a customer to suggest a selling price for his 8-unit apartment complex.

A) Determine net operating income

So you understand. Net operating income (or NOI) is one of the most important calculations made in regard to any real estate investment because it represents the property’s potential income after all vacancy and operating expenses have been subtracted; consider it as the investment property’s productivity, or measure of cash flow.

When the property is financed, for example, NOI represents the cash flow available to pay the mortgage; if the investor pays all cash for the property, and thus eliminates a mortgage payment, then it becomes the annual cash flow (i.e., cash flow before taxes).

As your first order of business, then, you would want to determine the net operating income for the property.

Here’s the calculation.

Gross Scheduled Income (GSI) less Estimated vacancy and collection losses = Effective Gross Income (EGI) + Income from other sources such as late fees, vending machines, and so forth = Gross Operating Income (GOI) less Annual operating expenses such as real estate taxes, utilities, insurance, maintenance and repairs, landscaping, management fees, legal and accounting, and so forth = Net operating income (NOI)

For our example, we’ll assume that the income property has a $54,000 GSI, $2,700 vacancy loss, $600 income from sources other than rent (i.e., coin-operated washers and dryers), and $20,760 annual operating expenses.

$54,000 (GSI) less 2,700 (Vacancy) = $51,300 (EGI) + 600 (Other Income) = $51,900 (GOI) less 20,760 (Operating Expenses) = $31,140 (NOI)

B) Determine the desired rate of return Next, we have to determine the capitalization rate we want to use for our calculation using one of two approaches. Either we research the market for similar income properties to arrive at a market cap rate or we use the customer’s desired rate.

For our example, let’s say that other similar apartment complexes in the area reveal an average cap rate of 6.23{ef6a2958fe8e96bc49a2b3c1c7204a1bbdb5dac70ce68e07dc54113a68252ca4} and in turn make the decision along with the seller to use that rate. Bear in mind, however, if the seller is adamant about using his own desired rate, and it’s different from the market rate, we would side with the customer.

In other words, if our seller preferred to use a capitalization rate of, say, 5.5{ef6a2958fe8e96bc49a2b3c1c7204a1bbdb5dac70ce68e07dc54113a68252ca4}, then we would calculate his rental property value based upon that rate of return.

C) Calculate the real estate value Lastly, now that we have the property’s net operating income of $31,140), and plan to use the market rate of 6.23{ef6a2958fe8e96bc49a2b3c1c7204a1bbdb5dac70ce68e07dc54113a68252ca4}, we can calculate our customer’s income property value with this formula: Net operating income / Cap rate = Real estate value, or $31,140 / 6.23{ef6a2958fe8e96bc49a2b3c1c7204a1bbdb5dac70ce68e07dc54113a68252ca4} = $500,000

Okay, now you’re ready to call your customer. Based upon a net operating income of $31,140 and a market cap rate of 6.23{ef6a2958fe8e96bc49a2b3c1c7204a1bbdb5dac70ce68e07dc54113a68252ca4}, you estimate that the customer’s apartment complex has a market value of $500,000.

Of course, for our purposes, we kept it simple. In a real life situation you, naturally, would want to use credible and accurate (not pie-in-the-sky) numbers to arrive at the property’s NOI. Moreover, you would want to consider other factors that could influence the property’s value.

Upside rent potential, for instance, or the ability to add more units to the property would surely increase its market value. Whereas, perhaps an impending zoning regulation that would make it a less desirable rental, and maybe negatively impact the rents or decrease occupancy levels, would drop its market value. But you get the idea.