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Formula – Capitalization Rate
C = I/P
C = Capitalization rate
I = Net income
P = Purchase price
The capitalization rate, or cap rate, is a ratio expressed as a percentage used to compare a specific income property against local standards.
It is often used together with GRM where GRM is used to estimate a property’s value.
For example if a GRM is 15.15 and annual rent is $10,000, the value of the house in question would be:
15.15 x $10,000 = $151,500
Assuming this is the purchase price, and the annual net income is $9,000, cap rate would be:
$9,000/$151,500 = 5.9%
With the cap rate of 5.9% now calculated, the next obvious step is to compare it against the performance of other comparable properties in the local area.
Should the appraiser determine from market data research that the average capitalization rate is 7%, then this rental property is performing below the market.
Should the standard be 5%, then this property is doing slightly better than the market.