A review of Cap Rates and how they are calculated.

One method for valuing commercial real estate based on it’s income is by using what is commonly referred to as a Cap Rate or Capitalization Rate. Simply put a Cap Rate is a ratio between the cash flow a real estate asset produces and the price paid for the asset, or capital cost.

For example: If a building is purchased for $2,000,000.00 and generated $250,000.00 in positive cash flow during the year the assets capitalization rate is 12.5%.

Cap Rate Formula

• Cash Flow / Cost = Cap Rate

• $250,000.00 / $2,000,000.00 = 0.125 or 12.5%

Cap rates measure how fast an investment will pay for it’s self. In the example above the real estate asset will reach full capitalization, which means that it will pay for it’s self in 12.5 years.

How do I use this in real estate valuation?

If we take the Cap Rate formula above and manipulate it slightly, then figuring out what to pay for an asset by determining it’s value given only the cash flow and cap rate is a simple process.

For Example, let’s say that the commercial building in the previous example is for sale and you know that the cap rate is 12.5% with an annual cash flow of $250,000.00. Then using the valuation formula below you can determine the value of the asset. In this example the asset value is determined to be $2,000,000.00.

Valuation Formula

• Asset Value = Cash Flow / Cap Rate

• $2,000,000.00 = $250,000.00 / 0.125

Gail Heist
NAI Kowallis & Mackey
www.NAIBoise.com
208.385.3216