If you are new to real estate investing, then you might not be familiar with the term “cap rate.”
The cap rate metric, also known as the capitalization rate, is one of the most commonly used metrics for calculating the rate of return of an investment property to help real estate investors determine whether a property is a viable investment or not.
There are multiple other metrics that are used in real estate investing for calculating the return on investment and other variations of it. The cap rate, however, is one of the most popular metrics and is among the most useful metrics to use before committing your money to a purchase.
So, what is cap rate? And how to calculate cap rate to determine the profitability of an investment property and to determine its value?
Let’s find out!
What is Cap Rate?
The cap rate, or capitalization rate, is a metric used to calculate the rate of return on investment in real estate investing based on the before-tax cash flow of an investment property and its current market value.
Not to confuse the cap rate with the cash on cash return, the two metrics are different in that while the cap rate takes into consideration the market value of the property with no regards to the method of financing used, the cash on cash return metric will only take into consideration the amount of actual cash or equity that the investor puts towards the investment.
In this sense, the cap rate metric is an indicator of the return on investment that the property will have in relation to its price, while the cash on cash return will measure the property’s return on investment in relation to the amount of cash that they paid for it.
Additionally, the cap rate can also be used in a reverse calculation to determine a property’s value, which can be useful if you’re trying to determine the price of the property that you’re trying to sell.
Of course, to know how to calculate cap rate, you first need to know what the formula for calculating it is:
Cap Rate = (Pre-tax Cash Flow / Property’s Value) X 100
The cap rate is typically expressed as a percentage value. This percentage indicates the amount of profit that the property will make each year of the total value of the property.
If an investment property has a cap rate of 10%, for example, it means that the property’s before-tax annual cash flow is equal to 10% of the total price of the property, and it will need 10 years to pay the full value of itself.
So, now it’s time to get into the math and learn how to calculate cap rate on your own.
How to Calculate Cap Rate?
Before learning how to calculate cap rate, it is important to get to know the other metrics or values that are included in the calculation process.
The main value or metric that you will need to understand in order to know how to calculate cap rate is the cash flow metric.
The cash flow of an investment property is the amount of rental income that it generates minus the amount of expenses that will apply.
The before-tax cash flow is the property’s cash flow without accounting for the taxes or including them in the expenses.
To put it simply, a rental property that rents out for $24,000/year ($2,000/month) and has annual expenses of $13,000 (before taxes) will have a before-tax cash flow of $11,000.
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Now, let’s make it a bit more complicated.
To give you a better idea of how to calculate cap rate with accuracy, let’s make some general assumptions and base a couple of examples on them.
Let’s assume that the property you’re buying is priced at $250,000. This property can be rented out for $1,800/month. The property has annual expenses that amount to $11,600.
In this example, let’s assume that you’re buying the property using all cash and no borrowed money.
Since the property has a monthly rental income of $1,800, its annual rental income will be $21,600.
Based on the $11,600 annual expenses, the property’s annual cash flow should be $10,000 ($21,600 – $11,600).
The calculation of the cap rate for this investment property would look like this:
Cap Rate = (Cash Flow / Property’s Value) X 100
Cap Rate = ($10,000 / $250,000) X 100
Cap Rate = 4%
This means that the property’s annual cash flow is equal to 4% of the property’s total value. While this might not seem like a good percentage, it is actually considered a solid investment and will have a reduced rate of risk.
In this example, let’s make things a bit more complicated.
Let’s assume that you’re using an 80% mortgage loan to purchase the investment property.
Now, since you’re using the cap rate metric, which does not account for the financing method used for the purchase, the method of financing might not seem relevant for your calculations.
However, since you’re borrowing money through a mortgage loan, a new expense will be included and it will affect your cash flow. This expense is the mortgage payback plus the interest rate.
In order to not make things too complicated, I will skip the process of calculating the mortgage payback and the interest rate, and I will assume that the added annual expense due to the mortgage will amount to $6,000 per year.
This means that the new annual before-tax cash flow of the property is now $4,000 ($10,000 – $6,000).
In this case, you will notice that the cap rate value has decreased drastically:
Cap Rate = ($4,000 / $250,000) X 100
Cap Rate = 1.6%
In a similar scenario, and in order to get the most accurate results, I recommend using the cash on cash return metric instead of the cap rate for calculating the rate of return because the cash on cash return of an investment property will take into account the method of financing more directly in its calculation, and it will make up for the reduced cash flow due to the mortgage payback and interest rate by only accounting for the amount of actual cash that you’ve paid for the property.
To give you an example, if you’re calculating the cash on cash return for the exact same property in my last example, you would only take into consideration the 20% cash paid of the property’s total value ($50,000), and its calculation will look like this:
Cash on Cash Return = (Cash Flow / Cash Invested) X 100
Cash on Cash Return = ($4,000 / $50,000) X 100
Cash on Cash Return = 8%
As a real estate investor, one of the most important skills to learn is how to calculate the different metrics for analyzing an investment opportunity and determining its rate of return.
Learning how to calculate cap rate for an investment property will be a powerful tool at your disposal, and it will allow you to make wiser investment decisions and greatly reduce the level of risk associated with your investment.
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