March 24, 2023

Cap Rate Calculator: How to Calculate Cap Rate for Real Estate Investing

Learn how cap rate is calculated and why it's an important metric for real estate investors.

Cap Rate Calculator

If you're a real estate investor or thinking about becoming one, you've probably spent considerable time mulling over what makes a good investment property. Should you buy an expensive home in a nice part of town with high rents or a more affordable option with middle-of-the-road rents?

Deciding between the two isn't an apples-to-apples comparison — the options are, on their face, incredibly different from each other. So, how do we determine what property is best for our real estate portfolio? This is where fundamental indicators and metrics come in. The most ubiquitous of the fundamental indicators in real estate investing is capitalization rate, or cap rate.

What is cap rate in real estate?

Capitalization rates — or cap rates for short — are an easy and dependable way to figure out what kind of return you can expect on your various investment properties. While they're not perfect and shouldn't be used in isolation, they can help investors make the right decisions for their portfolios when used in conjunction with other evaluation metrics. As the cap rate applies to any property, it facilitates direct comparisons between distinct properties, simplifying the task of evaluating diverse investment opportunities.

Why do real estate owners calculate rental property cap rates?

Real estate owners calculate rental property cap rates primarily to understand the potential profitability of an investment property. This metric offers a quick snapshot of the financial performance, allowing owners to determine whether it aligns with their goals and expectations.

Additionally, the cap rate serves as an important tool for comparing different investment opportunities. By utilizing cap rates, owners can assess properties of various types, sizes, and locations on a level playing field. This comparison helps them identify the most financially promising properties and diversify their portfolios.

Moreover, understanding the cap rate can be very useful when negotiating the property purchase price or sale of a property. It provides a basis for determining a reasonable price given its income potential. Sellers can use the cap rate to justify their asking price, while buyers can use it to evaluate if the price is fair or negotiate a better deal.

Finally, tracking changes in cap rates over time can offer valuable insights into market trends. Fluctuating cap rates can indicate changing market conditions, such as shifts in demand for rental properties or changes in the risk associated with real estate investments. This understanding can help owners make strategic decisions about when to buy, sell, or hold properties.

In essence, the cap rate is more than just a percentage — it's a dynamic tool for real estate owners seeking to maximize their returns and navigate the complexities of the property market.

How cap rate is calculated:

The Cap Rate, or Capitalization Rate, is calculated as the ratio of a property's Net Operating Income (NOI) to its purchase cost. It provides an estimate of potential returns on an investment property.

Let's break it down:

  1. Net Operating Income (NOI): This is the income generated from a property after deducting all operational expenses. It forms the numerator in the formula. Please note that operational expenses exclude mortgage interest, depreciation, and amortization.
  2. Cost to Purchase Property: This refers to the total price paid to acquire the Property. It forms the denominator in the formula.

Here's the formula for Cap Rate:

Cap Rate = Net Operating Income (NOI) / Cost to Purchase Property

Given the known cost of the Property, this calculation primarily hinges on accurately determining the NOI. Ensuring all relevant operational expenses are accounted for is crucial when calculating NOI for an accurate Cap Rate.

Rental property cap rate example

To bring clarity to the calculation process, let's apply it to a real-world scenario:

  1. Net Operating Income (NOI): The first component is the net operating income, which is the total income you can make from the Property in a year minus the operating expenses. In this example, the NOI is $200,000.
  2. Cost to Purchase Property: The second component is the total cost to purchase the Property. This is simply the price you paid to buy the Property. In this example, it's $2,000,000.
  3. Calculating the Cap Rate: To calculate the cap rate, divide the NOI by the cost to purchase the Property, then multiply by 100 to convert it to a percentage. In this case, we would divide $200,000 by $2,000,000, which equals 0.1 or 10%.
  4. Subtracting Debt Service: If there are additional costs like debt service (the cost of your mortgage), you subtract them from the NOI before calculating the cap rate. In this example, the debt service is $60,000. So, we subtract that from the NOI, leaving us with $140,000 ($200,000 - $60,000).
  5. Calculating the Adjusted Cap Rate: Now we can calculate the adjusted cap rate by dividing the adjusted NOI ($140,000) by the cost to purchase the Property ($2,000,000). The result is 0.07 or 7%.

So, in summary, the formula looks like this:

Adjusted Cap Rate = (NOI - Debt Service) / Cost to Purchase Property = ($200K - $60K) / $2M = 7%

What cap rate tells us:

In the above example, a 7% cap rate tells us that every year, our annual return on our investment is 7% of our purchase price. In other words, every year we own the Property, we will make back 7% of what we bought it for. So, to completely recoup our initial investment of $2,000,000, it'll take us a little over 14 years, as calculated below.

Years to Recoup Initial Investment = 100% / 7% = 14.3 years     

While cap rates can be an incredibly useful tool to compare several investments, evaluating a property by looking at its cap rate in isolation is nearly impossible. This is because there's no such thing as a "good" or "bad" cap rate.

It's tempting to assume that higher cap rates are better (because the higher the cap rate, the faster you'll recoup your initial investment), but higher cap rates almost always come with more risk. As such, real estate investors need to look at a prospective investment through many different lenses before deciding whether or not it's right for them.

What's a good cap rate for a rental property?

The concept of a "good" cap rate for a rental property can be somewhat subjective, as it can depend on a variety of factors, including the investor's goals, the local real estate market, the property type, the risk associated with the investment, and the current economic environment.

A higher cap rate often signifies a higher risk and potentially higher return, while a lower cap rate suggests a lower risk and lower return. Therefore, an investor looking for a higher return and willing to take on more risk might consider a property with a higher cap rate to be "good." In contrast, a more conservative investor might prefer a property with a lower cap rate.

Generally speaking, an average cap rate between 4% and 10% is considered typical in many markets. However, it's important to remember that this is a broad range, and what's considered a "good" cap rate within that range can vary.

Market conditions can significantly impact what's considered a good cap rate. For example, property prices might be higher in a hot real estate market, resulting in lower cap rates. On the other hand, in a slower market, cap rates might be higher.

The type and location of the Property can also influence the Property's cap rate amount. For example, commercial properties often have higher cap rates than residential properties. Likewise, properties in urban areas might have different cap rates than those in rural areas.

Investors should also consider their financial goals and risk tolerance when determining an acceptable cap rate. For some investors, a property with a 4% cap rate might be perfectly acceptable if it meets their other investment criteria, while others might be looking for properties with a cap rate of 8% or more.

Supplementary tools for a comprehensive investment analysis

To thoroughly understand the dynamics of your real estate investment and enhance the usage of the Cap Rate Calculator, you might find these other calculators particularly relevant:

Rental Property Vacancy Rate Calculator: Estimates the potential impact of vacancy on your Property's income, a vital component when determining your cap rate's Net Operating Income (NOI).

Return on Investment (ROI) Calculator: Provides a broader view of your Property's profitability, offering a beneficial perspective alongside the income-focused cap rate.

Amortization Calculator: Useful for mapping out your mortgage loan payment schedule, the key to understanding debt service's influence on your adjusted cap rate.

Property Management Fees Calculator: Important for accounting for all operating costs in your NOI calculation, directly affecting the accuracy of your cap rate.

NOI Calculator: Directly tied to your cap rate calculation, the result helps you accurately measure the income a property generates after operational expenses.

These tools collectively offer a comprehensive understanding of your investment's potential return, which can empower you to make informed real estate investment decisions when used alongside the Cap Rate Calculator.

Decoding the value of cap rate in investment decisions

The knowledge and precise computation of the cap rate is an indispensable part of real estate investing. It offers a robust tool for investors, aiding them in comparing diverse properties, forecasting probable returns, and making enlightened decisions that align with their financial objectives and risk comfort level.

Though the cap rate shouldn't be regarded as the sole determiner of a good investment, it provides a significant foundational layer for analysis and decision-making. Equally important is the recognition that what might be considered a "good" cap rate can be subjective and varies based on multiple factors such as market conditions, property type, and the investor's goals.

Therefore, a comprehensive approach towards the investment is advised, examining a variety of metrics, risks, and potential gains to ensure a well-informed and balanced investment decision.

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