One of the most popular methods used to estimate the rate of return on an investment property is to calculate the cap rate of the property.
A property’s cap rate is its rate of return based on the expected income that the property would generate.
So, how can you calculate the cap rate? What are the factors that enter the equation? And what are the limitations of the cap rate value?
Cap Rate Formula
For the math junkies out there, here’s what the cap rate formula looks like:
Cap Rate = Net Operating Income/Current Market Value
Just by looking at this formula, you can conclude that the cap rate is a real estate investment property’s rate of return based on the income that the property is expected to generate.
So, now that we know the two main factors that mash into the equation in order to calculate the cap rate of an investment property, let’s delve deeper into these factors, what they mean, and how you can determine their values.
Related: Why Is the Cap Rate Used in Real Estate? How Do You Calculate It?
Breaking Down the Cap Rate Factors
There are two main factors that are needed to calculate the cap rate of an investment property.
NOI (Net Operating Income)
The net operating income of an investment property is, basically, the annual return on that property minus all operating expenses.
Net Operating Income = Annual Return – Operating Expenses
So, how do you determine the NOI for an investment property that you’re interested in? Since the cap rate is best used to determine the rate of return on a rental property, then the first factor in determining the NOI for that property is the property’s annual rental rate. This is done by multiplying the monthly rent on the property by 12. If you don’t know what the monthly rent for the property is going to be, you can look at similar rental properties in the area and determine the average monthly rent based on them.
The second part of the NOI value is the operating expenses. Similar to the monthly rent rate, the operating expenses can be estimated based on other similar properties in the area as well as the property’s condition and the estimated costs of repairs and other expenses that will apply to the property.
Current Market Value
The current market value is straightforward. It is the price at which the property is currently listed on the market.
Since the current market value is needed to calculate the cap rate of an investment property, relying on cap rate can be problematic in some cases. For example, if the property wasn’t bought by the owner, but instead was given as a gift or inherited, then the cap rate cannot be calculated since the actual cost of the property was zero.
Additionally, you cannot calculate the cap rate of an investment property based on its original cost if the property’s market value has changed drastically over a long period of time. So, if you’ve bought a property for $300,000 in 1992, and that property’s market value increases to $4,000,000 over 25 years, you cannot calculate the cap rate for that property based on its original cost as it would give very inaccurate values.
For this reason, in order to calculate the cap rate, you will always need to know the current market value of the property.
Note: Click Here to find the best-performing markets based on their Cap Rate!
Related: Cap Rate vs. Cash on Cash Return
Calculate the Cap Rate: Example
Let’s suppose that Jennifer wants to buy a property for $500,000. In order to calculate the cap rate for this property, Jennifer first needs to figure out the NOI.
To do that, Jennifer has made a market study for the area, and she has determined that the average rent that other landlords demand on properties that are similar to this property is $3,200/month, so the annual rental income for the property would be around $38,400 ($3,200 X 12).
To calculate the NOI, Jennifer now has to figure out the operating expenses for the investment property and subtract them from the annual rental income.
Jennifer has conducted a research and devised a strategy, and she concluded that the operating expenses of her property would be around $25,600 (operating expenses typically cost around two-thirds of the rental income).
Finally, Jennifer ran the numbers on her calculator:
NOI = Rental Income – Operating Expenses
NOI = $38,400 – $25,600
NOI = $12,800
Now Jennifer has all the values she needs in order to calculate the cap rate for her investment property. Her calculations would go like this:
Cap Rate = NOI/Current Market Value
Cap Rate = $12,800/$500,000
Cap Rate = 0.025
But since cap rate is expressed as a percentage, this value is multiplied by 100, giving the final result:
Cap Rate = 2.5%
Note: To use Mashvisor’s Cap Rate calculator, click here!
Related: What’s a Good Cap Rate for Investment Properties?
While cap rate is used by most real estate investors to determine the rate of return on an investment property that they intend to rent out, there are some limitations to the use of the cap rate.
Cap rate for short-term investments, for example, is not a very useful value to calculate since you will have very little time to develop a reliable cash flow, making the property’s NOI very difficult or straightforward impossible to determine.
Although the cap rate is a popular and an easy ratio to calculate and use in real estate investing, it should not be the sole factor on which a real estate investment decision is made. Several other factors should be taken into consideration, such as the growth or decline of the property’s cash flow, the property’s appreciation, or the other metrics used to estimate a property’s rate of return.
Are you ready to use the cap rate when making your real estate investment decisions? Use Mashvisor and find investment properties based on readily calculated cap rates, allowing you to save both time and effort when making your investment decisions.