Real Estate AnalysisLearn How to Calculate Cap Rate to Buy the Best Investment Properties Always by Nadia Abulatif December 29, 2017February 11, 2019 by Nadia Abulatif December 29, 2017February 11, 2019We know for sure that successful real estate investors have made a fortune of their business. However, this was no coincidence. It all started with buying the best investment properties that generate the most cash flow. In order to do so, they have learned how to calculate cap rate for any real estate property.Now, we believe you are curious about what the cap rate means. No worries, this blog is dedicated to the sole purpose of teaching you, as a new real estate investor, how to calculate cap rate.Related: Cash on Cash Return Calculator Is a Must for Successful Real Estate InvestorsNevertheless, let us start with the definition of cap rate before we get to the actual steps of how to calculate cap rate.How to calculate cap rate: Breaking down cap rateWhen you buy an investment property, the first thing you do is look at various properties. However, have you ever wondered why real estate investors end up choosing the one they pay for? It is the cap rate.The cap rate is basically the formula used to compare investment properties based on the rate of return on investment they have made or are about to make.How to calculate cap rate: FormulaCalculating the cap rate is the easiest process to do if you just follow this simple formula:Cap rate = Net operating income/Property valueSo, in other words, the cap rate is the net operating income divided by the value of the property at the time of the purchase. In order for us to break it down in an example, let us first break down the components of this formula:Net operating income:The net operating income is a metric professional real estate investors use to spot an income property. In other words, it is a calculation that helps them determine whether a certain property is generating a good income. The math is simple. You basically subtract the annual property expenses from the annual revenue, while keeping in mind that the figures you get are before-tax figures.Property value:This one is as straightforward as it sounds. After you have calculated your net operating income, you divide it by the actual value of your property at the time of the purchase. Now, the rate you get is actually the return on investment estimated for the property.How to calculate cap rate: Break it down!Let us say that you, as a real estate investor, have an investment property. This property was worth $500,000. Now, the investment property is generating a revenue of $100,000 annually, and you spend $20,000 in property expenses. Here is how to calculate the cap rate for this investment property:First of all, look at the formula and check if you have all your components:Cap rate = Net operating income/Property valueHere, we have the property value, but we do not have the net operating income. Therefore, we are going to calculate that first.Net operating income (NOI)= Revenue – Property expensesNOI= $100,000 – $20,000 = $80,000So, now that we have that, let’s go back and apply it to the cap rate formula:Cap rate = $80,000/$500,000 = 16%Related: What’s a Good Cap Rate for Investment Properties?How to calculate cap rate: How is it different from the cash on cash return?When an investment property is purchased with a loan, real estate investors usually put a down payment on it. Therefore, a cash on cash return is a metric which real estate investors use to calculate the return on the actual cash they have invested, which means that it takes into consideration the down payment, not including the mortgage. For example, if you are buying a rental property that is worth $200,000 and financed it with a loan, paying only 10% in down payment, the 10% down payment on this purchase is $20,000 and the loan has covered $180,000. When you calculate the cash on cash return for this one, you only take into consideration the down payment which is the actual dollars you have invested in the property.The formula for calculating the cash on cash return is as the following:CoC = (Annual pre-tax cash flow/Total cash invested) × 100%If we are to compare the cash on cash return to the cap rate, then the difference is simple and obvious. The cash on cash return only calculates the return on the actual cash invested, while the cap rate calculates the overall estimated return on investment, considering the value of the property, not taking into account any loans included.How to calculate cap rate: When to use cap rate and when not to use it?Professional real estate investors usually use the cap rate to determine the return on investment a certain property is generating. However, it is mostly used by investors in the commercial real estate investing sector. Still, this does not mean that if you are a residential real estate investor, you can’t use it.If we think about the advantages of learning how to calculate cap rate for a certain investment property, then it is worthwhile. With the cap rate, you can compare different properties when buying your first rental property. Therefore, you will have an indicator of what rental property is going to generate the most rental income.Another way you benefit from calculating cap rate is predicting certain market trends. By calculating the cap rate, you can predict where a certain housing market is heading in the next few years. Again, this means you can actually decide whether a certain rental property is worth investing in.Then again, you have cases when you can’t use a cap rate. One of these cases is short-term real estate investment strategies as there is no revenue, and therefore no net operating income. Strategies like fix and flips are an example of cases where the cap rate should not be used.Related: What Are the Best Tools for Real Estate Market Analysis?How to calculate cap rate: What affects cap rate?Just like any other formulas, there are a few factors that affect the cap rate, which means that the actual cap rate has to match the cap rate you have calculated when buying an investment property. Furthermore, here are the factors that affect the cap rate:The age of your investment property.The population growth in that area.The job market/economic growth in that area.The duration of the lease agreements signed between you, as the landlord, with your tenants.For more on cap rate and other real estate investing metrics, go ahead and sign up to Mashvisor. Start Your Investment Property Search! START FREE TRIAL Cap RateCash on Cash ReturnCostsProperty ValuationRental Income 0FacebookTwitterGoogle +PinterestLinkedin Nadia AbulatifNadia Abulatif is an experienced Content Writer at Mashvisor. She was a trainee lawyer before switching to writing about real estate. She is currently doing an LL.M. in Human Rights and International Law. Previous Post What’s the Most Important Return on Investment Formula in Real Estate Investing? Next Post How to Buy Foreclosed Homes from Banks and Why They Are So Great Related Posts This Is How Not to Calculate Cash on Cash Return for Investment Properties Become an Expert on Comparative Market Analysis with Our Guide How to use cap rate to decide on the best investment Cap Rate vs. Cash on Cash Return: The Formula to Success in Real Estate Investing? Real Estate Market Analysis vs. Home Appraisal: What’s the Difference? 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