Question

What are the advantages and disadvantages of using capitalization rates with an income property?

Answer 1

The capitalization rate value is expressed as a percentage value that measures the relationship between the NOI (net operating income) of an income property and its current market value.

Advantages

The cap rate is the most commonly used metric for evaluating an income property by real estate investors, agents, appraisers, and even banks. This is because the capitalization rate value takes into account the operating expenses and the vacancies of the income property, making it a more accurate and factual measurement of the property’s performance

Disadvantages

The main disadvantage in using the cap rate to analyze an investment property is that the cap rate only shows the value of a property based on the first year's stabilized net operating income. If the NOI of a property changes in subsequent years, the cap rate changes, therefore the value. The cap rate has an inverse relationship to value. Assuming the NOI remains the same, if the cap rate increases, the value decreases and vice versa.

The other disadvantage of using the cap rate for evaluating an income property is that it is challenging to determine the cap rate value for a sold property due to the difficulty of determining a sold property’s operating expenses.