How to Calculate Cap Rate Most Effectively: A Simple Guide

What if you buy a rental property and reach financial freedom through it? What happens when you buy a rental property and end up way in over your head? Suppose you speculate and guess, then realize when it’s too late that you should have planned before acting? We all have fantasized about reaching financial freedom and security through working hard. However, that’s not the only way to go, my friend! The path to achieving financial comfort is investing here and there. Investing can come in many shapes and sizes. Arguably, buying rental properties is one of the best investment strategies that you can replicate all the way to the bank. For this reason, knowing how to calculate cap rate for any property is indispensable to any investments in the US housing market.

What is a cap rate?

The cap rate is short for capitalization rate. It’s one of the many analytical metrics used to determine the profitability of a rental property. Knowing how to calculate cap rate can give you an accurate indication of the annual gross profit rate while factoring in expected income. It may sound overcomplicated for a novice real estate investor, but it’s a lot more relatable than you think!

Let’s take a hypothetical rental property as an example: Assume the property’s purchase price was $90,000, and the annual gross income was $9,600, and the total annual expenses are $2,800. As a result, the cap rate is the expenses subtracted from the income and then divided by the purchase price.

Related: Basics of Cap Rate in Real Estate Investing.

How to calculate cap rate for any investment property you have your eyes on

If you’re not a math whiz, it may seem a bit daunting to place your investment’s future on simple calculations. But the process of knowing how to calculate cap rate won’t take longer than five minutes of your time, and you should invest those five minutes to improve your real estate education to determine the return on investment a property can offer. Here is how to calculate cap rate in simple detailed steps:

Figure out the precise annual gross income of the potential rental property

The gross income is basically any income generated by a property. Let’s say you have a single-family rental property. The annual gross rental income is what the rental property generates yearly.

Example: If the monthly rental income = $800, then the annual gross income is $800 X 12 = $9,600.

Deduct the operating expenses from the annual gross income

Expenses should be inclusive of any costs you’ve had or will have to endure during the year. This includes maintenance costs, taxes, utility costs, and even property management. This step is quite important in knowing how to calculate cap rate, as leaving out an important cost can throw off the balance of your projections or calculations.

Example: If the annual operating expenses are $2,800, then the annual net income is $9,600 – $2,800 = $6,800.

Extract the cap rate by dividing the net income by the property’s purchase price

The last step in calculating the cap rate for your rental property is simply dividing the net income by the purchase price.

Example: If the property’s purchase price is $90,000 and the net income is $6,800, then the cap rate is $6,800 / $90,000 = 0.075 which is 7.5 %

Use cap rate to compare rental properties

Knowing how to calculate cap rate is a major part of a comparative market analysis. You must combine it with real estate comps to make sense of it. Most importantly, do not rely on using the cap rate as a sole metric to measure your investment. It makes a lot more sense to incorporate it in the decision along with other analytics.

Related: How Can You Assure a Good Cap Rate for Your Rental Properties?

When comparing two rental properties, assume you found the cap rate for one to be 5% while the other offered 9%. This can be easily deciphered into favoring the second one as it has more potential earnings for your initial investment.

How to calculate cap rate with Mashvisor

Mashvisor offers a comprehensive rental property calculator that cuts through the noise to deliver reliable real estate investment solutions. As a matter of fact, it eliminates the need to know how to calculate cap rate and the need to do manual calculations and predictions through immediate feedback and readily-available data. To dive more deeply into Mashvisor’s rental property calculator, it offers the many metrics that are pillars of real estate evaluation. In return, this makes your investment decision solid and reliable.

Related: Investment Property Calculator – A Simple Guide on Using it.

These metrics include the cap rate, cash on cash return, and rental income. Additionally, you can compare different real estate investment strategies and rental strategies to determine the best stream of income to venture into. It provides data for both Airbnb rentals and traditional rentals. If you’re hesitant to invest in real estate because you’re not sure where to begin, start with your 14-day free trial with Mashvisor’s analytics by clicking here.

After all is said and done, you need to know how to calculate cap rate, as it will remain the main pillar for real estate investors to rely on. Ironically, novice real estate investors often forgo the importance of the cap rate and even proceed with a property sale without even considering it. As a result, they can experience shortages and even loss as they left space for speculation and guessing. Ensuring that all matters are factored in with your initial calculations can help you in spotting the best positive cash flow properties! Take it as free advice, never speculate and guess when it comes to your hard-earned cash!