Capitalization Approach to Value

Several of our students have been having problems understanding the cap rate, or capitalization approach, to estimating value of an income producing property. If you remember that the higher the net income produced by a property (or investment), the higher the value, it follows that a property returning 3% income is worth less that one returning 7%, all other things being equal and not considering radical changes in the properties' economic environment. By researching the sold statistics of income producing properties, an agent can calculate the rate of return investors are after. In other words, if most of the sold properties show a net income of around 5% (not considering cost of financing), then it is probably safe to estimate that the property you're trying to value should use 5%, or perhaps more, as a benchmark for estimated market value. Using the formula of Income (net after expenses) over Rate (in this case .05), estimated value can be calculated. So, if the subject property produced a net income of $35,000 and we know that figure should be around 5% of the value for investors to be interested, we can simply divide income by rate and suggest a market price of $700,000.