The process sounds scary, but it is actually fairly easy. Conceptually, you want the answer to the following question:
How much would someone pay to receive a particular cash flow from a rental property? This calculation requires the use of something called a capitalization rate, or cap rate as it is usually called.
You can better understand this concept through an example. Suppose you wanted to earn $12,000 per year from an investment. You could buy a bank certificate of deposit (CD) that pays 3% interest, which means you earn $0.03 (3%) per year for every $1 of the CD.
To find out the size of the CD you need to purchase to earn $12,000 per year when interest rates are at 3%, you write out the following:
$ ? x 0.03 = $12,000.
The mystery number can be discovered by dividing $12,000 by 0.03. The answer is $400,000. So in order to earn $12,000 a year, you will have to deposit $400,000. Although this terminology is not used in the context of certificates of deposit, we might say that a cash flow of $12,000 per year, at a cap rate of 3%, results in a value of $400,000.
Suppose, instead, you were looking at a piece of rental real estate. The total rent possible each year is $28,000. Operating expenses, such as real estate taxes, insurance, maintenance, repairs, advertising, commissions, and office overhead might cost you $16,000 per year.
Mortgage payments are not considered operating expenses, so they are not relevant in this calculation. Depreciation deductions on your taxes are also not considered operating expenses, so they are not relevant, either. If you start with $28,000 per year in gross income and subtract $16,000 per year in operating expenses, you are left with $12,000. That is called the net operating income (NOI).
What is the value of a piece of rental property with an NOI of $12,000 per year? You must select a cap rate, something that will perform the same function as the interest rate in the previous CD example. Whereas you might invest cash in an FDIC-insured CD and earn only a 3% return, you might desire a better rate on a riskier real estate venture. How much more interest would you want to earn on your investment? The number you choose is called the cap rate.
In any community, commercial real estate brokers and mortgage lenders can tell you the prevailing cap rates for various properties at that time. Cap rates change as interest rates change and as market conditions change. They are not carved in rock for all time.
You might find that relatively modest rental houses in fair condition sell on cap rates of 13%. In other words, if an investor were paying cash to buy a rental house, he or she would want the NOI to be 13% of his or her purchase price.
Using the same formula we used to calculate the size of the CD, you would write:
$ ? x 0.13 = $12,000.
The mystery number can be discovered by dividing $12,000 by 0.13. The answer is $92,307.69. If prevailing cap rates are 13% for similar properties, an investor would probably pay no more than $92,000 or so to acquire a rental house that will give him or her $12,000 per year in cash flow.