Cap Rate Calculator: How to Calculate Cap Rate & What it Means
Learn how cap rate is calculated & why it's important for real estate investors
Cap Rate Calculator
If you’re a real estate investor or thinking about becoming one, you’ve probably spent a considerable amount of 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 - our options are, on their face, incredibly different from each other. So, how do we decide 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.
What is Cap Rate?
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 investment. While they’re not perfect and shouldn’t be used in isolation, when used in conjunction with other evaluation metrics, they can help investors make the right investment decisions for their individual portfolios. Since they can be applied to any property, they can also help us make apples-to-apples comparisons between seemingly disparate properties.
How Cap Rate is calculated:
Cap rate is defined as the ratio of a property’s net operating income to its purchase price. Net operating income (NOI) - the numerator in the formula below - is defined as the income generated from a property after accounting for all the expenses related to operating that property. The denominator is just the property’s purchase price.
Cap Rate
=
Net Operating Income (NOI)
Cost to Purchase Property
The cost of property is known, so this calculation is relatively simple if you have the property’s net operating income (NOI). When calculating NOI, it’s important to remember to subtract all operating expenses related to the property (excluding mortgage interest, depreciation, and amortization) from the property’s income. Let’s explain with an example.
Cap Rate
=
Net Operating Income (NOI)
Cost to Purchase Property
=
$200K – $60K
$2M
=
7%
The cost of property is known, so this calculation is relatively simple if you have the property’s net operating income (NOI). When calculating NOI, it’s important to remember to subtract all operating expenses related to the property (excluding mortgage interest, depreciation, and amortization) from the property’s income. Let’s explain with an example.
Say you purchase a property for $2,000,000. You collect $200,000 in rent annually and spend a total of $60,000 on expenses related to the property. Your NOI would be $200,000 – $60,000, or $140,000. To calculate cap rate, we just divide our NOI of $140,000 by the purchase price of $2,000,000, which gives us a capitalization rate of 7% cap rate.
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% Cap Rate =
100%
7%
= 14.3 years
While cap rates can be an incredibly useful tool to compare a number of investments, it’s nearly impossible to evaluate a property by looking at its cap rate in isolation. 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, it’s vital for investors to look at a prospective investment through many different lenses before deciding whether or not it’s right for them.