Calculating cap rate is a part of the real estate investment analysis process. However, is it really a big deal when investing in property?
We know math is not a favorite subject for many. But, in cases such as real estate investing, unfortunately, there is no way to go without at least some math. Don’t worry though, when it comes to calculating cap rate, it does not have to be a complicated process. Sure enough, you can do it simply on a piece of paper. Or, you could just use the cap rate calculator for that.
Related: Cap Rate vs. Cash on Cash Return
So, before we get to show you how to calculate cap rate, let’s get to some important aspects here. We are going to start with the definition and move on to the calculation process, what is a good cap rate, and why it is important in real estate investing. Finally, we are going to tell you the best place to find a cap rate calculator! Now, let’s get right into it!
What is a cap rate in real estate investing?
As a form of return on investment calculations, the cap rate is the estimation of the returns a real estate investor should expect based on the annual cash flow in addition to the total property price. The annual cash flow is what we call the net operating income (NOI). Moreover, the total property price is the amount of money you have invested including any external financing strategies. So, basically, it is a form of investment property analysis that is used to determine the rate of return on a certain amount of money invested in an income property.
Related: How to Assure a Good Rental Property Return on Investment
As for the cap rate formula, it is very basic. Simply, you calculate the net operating income (by adding up the amount of monthly cash flow you’ve received throughout a whole year). After that, you divide that number by the total property price. Therefore, the cap rate formula should look like this:
Cap rate = NOI / Total property price
See, it’s not that complicated. Just read the next section to see how we apply everything to the formula!
The process of calculating cap rate for a rental property
Let’s say I am looking into a rental property that is selling for $750,000 (I know that is expensive but let’s just go with it!). I applied for a mortgage and got $600,000 while I provided $150,000 for a down payment.
After performing the comparative market analysis, I find out that I could charge $2,000 for rent each month. As for the monthly rental expenses, here are the numbers the owner provided me with for the previous year:
Property maintenance: $200/mo
Insurance: $300/mo
Professional property management: $350/mo
Unexpected costs: $200/mo (which occurred only twice in the last year)
So, now, what is the cap rate for this particular rental property?
Let’s start calculating the cap rate by figuring out the NOI for this property.
1) The annual gross income = $2000*12 = $24,000
2) The annual rental expenses = ($200+$300+$350)*12 + ($200*2) = $10,600
3) The NOI = $24,000 – $10,600 = $13,400
Now, let’s get to calculating cap rate by applying the numbers to the cap rate formula:
Cap rate = NOI / Total price
= $13,400 / $750,000 = 1.7%
At this point, we are done with calculating cap rate. Still, we are left with the question: “Is that a good cap rate?” We are going to answer this question in the next section!
What is a good cap rate?
So calculating cap rate is not the end of it. Now that you have a number on hand, you want to analyze it. For successful real estate investors, a good cap rate would be anywhere from 8% and above to consider it as the best real estate investment. This means that the previous number (1.7%), is far from being a high cap rate for such an expensive investment property. BUT, we do have something to say about this number.
You see, it doesn’t necessarily mean that the property is not profitable or it won’t be profitable in the future. Many successful real estate investors were able to make a fortune investing in low cap rate properties. However, there are factors that were the main determinants for that. Sometimes, a property is not so profitable at the moment you want to buy it. But, when looking at predictive analytics, you could see that the real estate market in that certain location is expected to head up in the near future. This means, that even though it is showing low performance at the moment, in the future, the real estate market and the investment property are expected to get to a higher cap rate.
Indeed, it does not sound like a low risk investment as you will have to be a pro to get to that conclusion. Still, it is worth it for the most part as long as you know what you are doing.
What is the importance of calculating cap rate for investment properties?
We bet you can already see at least a fraction of the cap rate’s significance in real estate investing. But, we’re going to lay it out for you here:
Calculating the cap rate will always help a real estate investor to find an investment property that is lucrative. As we have demonstrated before, it is an estimation based on NOI and property price. This means, that if you get a high cap rate, it’s either the property price is low or the rental income is high. Either way, it is to your own benefit!
Another way calculating cap rate assists real estate investors is with market trends. This is especially true for commercial real estate investing. By calculating cap rate in the present time and comparing it to past analytics of cap rate, you can always predict the future cap rate for a certain property. In other words, you can get a glimpse of where your investment property is heading a few years from now. If it’s showing higher cap rates, it means that the property will appreciate and as a result, you’ll start receiving higher rental income.
Related: Best Places to Invest in Real Estate Based on Cap Rate
Finally, calculating cap rate has its own limitations of usefulness. In general, there is one limitation: irregular cash flow investments. Not that you can’t calculate it, but you can’t rely solely on cap rate as you will have to apply other forms of return on investment calculations.
Where can you find the best cap rate calculator?
When you are searching for the best real estate investment tools, there is no better place than Mashvisor to find them. So, let us present our rental property calculator to you. Of course, you are wondering what does that have to do with calculating cap rate? But, do not worry. Our investment calculator is a combination of the cap rate calculator in addition to other tools crucial to your real estate investing business. So, why not start by signing up here and then exploring our products and services for the best real estate investments?!