Table of contents
Table of contents
The capitalization rate (also known as cap rate) is used in commercial and residential real estate to describe the projected rate of return on an investment property. Cap rate is calculated by dividing the net operating income by the current market value of the home. Investors determine the probable return on their real estate investment by using this metric.
While using the cap rate can be an excellent start to find if an investment property is suitable or not. It shouldn’t be the sole indicator since cap rates don’t consider the time, money, neighborhood and future expected cash flow if renovations are done to the property.
Main Takeaways
- Cap rate is calculated by dividing the net operating income by the current market value of the home.
- This calculation gives an estimate of the possible return on an investor’s real estate investment.
Capitalization Rate Formula
Capitalization Rate = Net Operating Income (NOI)/ Current Market Value
The Cap Rate is the most common way to estimate the profitability of real estate investments since it indicates the possible returns of an asset over the period of a year.
There are different formula types, but the most commonly used one is taking the net operating income (NOI) and dividing it by its current market value.
Breaking Down NOI
NOI is the expected cash generated from the property. So, for example, if you have a rental, this will be your rent. If you have an apartment, on top of rent, you may have parking and laundry mat fees that add to your cash generated at the end of the year. Then you will subtract all the expected money generated with expenses to receive your NOI. Expenses include taxes and any money you put in to make the house rent or for sale ready.
The market value is what the property is worth the day you bought it.
Are High Cap Rates Always A Good Thing?
While theoretically, a high cap rate is a good thing, you shouldn’t always lean on this number. The reason is that math equations can’t calculate humans. For example, let say you see a property for sale in a sketchy part of town, and the calculations are spitting back out a 13% cap rate. You may think to yourself, that’s a great deal! In reality, it may be a terrible deal. Since it’s in a rougher part of the neighborhood, you may end up spending more on maintenance, costing you your profits.
Example using the Capitalization rate formula:
Capitalization Rate = Net Operating Income (NOI)/ Current Market Value
The house you want to buy as a rental is expected to cash flow $850 per month (rent). $850 x 12 (One full year in months) = $10,200.
Capitalization Rate = $10,200-Expenses / Current Market Value
You can find the tax amount on the county treasury or ask your real estate agent, but for this example, we will say taxes and all expenses included will add up to $2,950.
Capitalization Rate = $10,200-$2,950=$7,280/ Current Market Value
For our market value, let’s say we paid $85,000 for the house.
Capitalization Rate = $7,280/ $85,000
8.56% = $7,280/ $85,000
After all the calculations, we come out with a cap rate of 8.56%. This is simply calculating your cash return. One crucial factor you are not calculating in this formula is appreciation, making real estate even more lucrative than the stock market since the stock market can’t appreciate. Real estate doesn’t always appreciate, but in the long-term, history has proven to go up. Let’s say, on average, the house is appreciating 3% every year, well now that makes your 8.5% go to 11.5%, outpacing the S&P 500.