The cap rate, or capitalization rate, is one of the most basic real estate metrics every real estate investor should know. However, we dedicate this blog to real estate investing for beginners. Therefore, here’s what you need to know on how to calculate cap rate for your investment property.
So, without further due, we will be talking about cap rate in full details. So, keep on reading to find out what makes successful real estate investors.
Related: Investment Property Returns Dictionary
How to calculate cap rate: What is cap rate?
The cap rate is one of the most important real estate metrics that every investor should know about. It does not matter whether you are an experienced or a new real estate investor, cap rate is a must. The formula for cap rate is as follows:
Cap rate = Net operating income (NOI)/Market value of the investment property
The cap rate is mostly used in commercial real estate investing. It is basically a tool that helps to estimate the return expected on a real estate investment property. It is also used to compare similar investment properties in one location.
As you have noticed, part of the cap rate calculation is the NOI, aka net operating income. The NOI is simply the property expenses subtracted from the income generated by the property. Keep in mind that the NOI is the figure before tax, which means that it excludes loan payments interest, depreciation, and other taxes.
Meanwhile, the value of the property is the actual market value of your investment property. So, the NOI should be divided by the market value of the investment property in order to get a percentage of the annual return on investment.
How to calculate cap rate: Cap rate in action
An example of how to calculate cap rate:
Let us say that you are considering buying your first rental property as a new real estate investor. You find a property that costs $300,000. You expect this investment property to generate $50,000 a year in rental income after subtracting all property expenses. So now apply these numbers to the formula as the following:
Cap rate = Net operating income (NOI)/Market value of the investment property
Cap rate = $50,000/$300,000 = 16%
However, you should keep in mind that this is only a simple example of calculating the cap rate. You must understand that sometimes, in reality, it gets a bit more complicated depending on other factors surrounding your investment business.
How to calculate cap rate: What adjustments apply to cap rate
A cap rate is an indicator of a profitable investment property. Therefore, you must know that in order to have a higher cap rate, the rental property has to generate higher NOI while having the same market value. If the opposite happens, it means that the cap rate of your property is declining, and that is when you need to worry.
How to calculate cap rate: What to use cap rate for
The cap rate is obviously used to evaluate the return on investment for a certain property to see if the investment property is worthwhile or not. A high cap rate indicates a very positive cash flow that the property generates, which is great news. However, you should keep in mind that the cap rate is an annual ratio, therefore, the percentage you get is per year.
Calculating the cap rate usually helps real estate investors evaluate the investment property properly. It also helps them stay up-to-date with the latest real estate market trends. For new real estate investors, we recommend that they learn this as part of their real estate education. It will be of great help for them when they decide to buy an investment property.
How to calculate cap rate: What affects cap rate?
When it comes to learning how to calculate cap rate, you must understand that there are a few factors that affect it. Therefore, this means that there isn’t any specific measurement of a good cap rate for a profitable investment property. Here are some factors that play a major role in determining a good cap rate:
First, take into consideration the location of the investment property. As we mentioned, the whole point of learning how to calculate cap rate is to estimate the return on investment for a certain rental property. Therefore, obviously, different investment properties in different locations have different cap rates. For example, if you decide to buy an apartment building in the middle of a busy city like New York, then the cap rate is going to be high, of course. But if you decide to buy a house in the middle of a forest with nothing around, then you should expect a high vacancy rate, thus, a low cap rate.
Another factor that affects the cap rate is the property type. Sure enough, you cannot expect to have the same cap rate for an apartment building and a single-family home!
Related: What’s a Good Cap Rate for Investment Properties?
How to calculate cap rate: When not to use cap rate
First of all, you should not use cap rate as the ultimate scale for a good real estate investment property. It is an estimation, which means that it might change as other factors appear along the way.
Second, you should not use cap rate for short-term investment strategies, for instance, using the cap rate to estimate the return on a property you are planning to flip makes no sense. Therefore, it is not suitable for fix-and-flips, for example, since the income does not come from a rental property.
How to calculate cap rate: How is cap rate different from cash on cash return?
Many new real estate investors get the cap rate and the cash on cash return mixed up. You must know that though they are a bit similar, they are still used for different purposes. The cash on cash return is a metric determined by dividing the cash flow after all expenses by the original sum of money invested, while the cap rate is the NOI divided by the property’s price.
Related: Cap Rate versus Cash on Cash Return: Which One Is the Ultimate Metric to Measure ROI in Real Estate?
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