How To Calculate Cap Rate: Calculator, Formula, & FAQs

How To Calculate The Cap Rate Of A Property

Here’s a step-by-step guide for calculating the cap rate of a property:

1. Establish the Property Value: Assume the market value or selling price is $210,000 for this example.

2. Determine Gross Rental Income: This refers to the annual total income from tenants. Let's say it totals $32,000 per year.

3. Evaluate the Vacancy Rate: Consider a scenario where the property remains unoccupied 3% of the time.

4. Calculate Operating Expenses: Imagine monthly expenses are $550, equating to $6,600 annually. This represents approximately 21% of your gross income. Adjustments for operating expenses can be made in the calculator's advanced mode.

5. Compute the Net Rental Income with the adjusted formula:

$\text{Net Income}$

$=$

$(100\mathrm{\%}-21\mathrm{\%})$$\times$$(100\mathrm{\%}-3\mathrm{\%})$$\times$$\mathrm{\$}32,000$

$=$

$0.79\times 0.97\times \mathrm{\$}32,000$

$=$

$\mathrm{\$}24,465.60$

6. Determine the Cap Rate by dividing the net income by the property value:

$\text{Cap Rate}=\frac{\mathrm{\$}24,465.60}{\mathrm{\$}210,000}=11.65\mathrm{\%}$

Using our free cap rate calculator above, you will easily be able to input your values and find your capitalization rate. 

This simplifies the cap rate calculation, offering an insightful evaluation of your investment's yield.

Read Also: NOI In Real Estate: Net Operating Income Explained

Cap Rate Formula Examples

Let’s say, for example, you are considering purchasing a multifamily rental property for $750,000 but don’t want to follow through with a purchase until you have a better idea of the expected cash flow.

In this cap rate formula example, you must gather the purchase price and net operating income. We already know the purchase price is $750,000.

That means you need to calculate the net active income. To do so, determine how much the property will bring in each year in rent (not monthly rent) and subtract the costs of keeping the property in operation, like property management fees and maintenance costs.

For this cap rate formula example, let’s say the net operating income is $50,000 per year. Now that we have all the variables, the next step is dividing the NOI ($50,000) by the purchase price/current market value ($750,000):

$50,000 ÷ $750,000 = 0.0667

The answer you get is 0.0667. However, to express the answer as a percentage of return, you’ll need to multiply the answer by 100:

($50,000 ÷ $750,000) × 100 = 6.67%

This brings our final solution to 6.67%. In this example, you can expect a 6.67% return on your investment.

What Is A Good Cap Rate?

A “good” cap rate tends to rest somewhere in the neighborhood of 5.0%.

However, before you get caught up in aiming for 5.0% on every investment, it’s important to note that not all cap rates are created equal. More importantly, not all investors view returns and risks the same. Therefore, it’s important to underscore the difference between a good cap rate and a safe cap rate.

Investors looking to cover the purchase cost sooner rather than later should look for a cap rate on the higher end of the “good” spectrum, which may be closer to 10.0%. Investors who prioritize safety, however, will want a lower cap rate, perhaps around 4.0%.

What Is A Good Cap Rate For A Rental Property?

No cap rate is universally good for all rental properties. If for nothing else, different investors have different expectations. One investor thinks a good cap rate for a rental property, and another thinks it's abysmal. A good cap rate rests between 5.0% and 10.0%.

Looking at it from another perspective, a lower cap rate suggests a higher purchase price relative to the income generated. In other words, the cap rate implies potentially safer and lower returns. Conversely, a higher cap rate suggests a lower purchase price relative to income, potentially indicating better returns and slightly more risk.

What Is A Good Return On Commercial Property?

A “good” annual return on commercial real estate can range from 5.0% to 10.0%.

However, as previously mentioned, “good” is a relative term. Some investors may be comfortable going outside the “good” range, whereas others won’t consider a commercial investment that returns anything less than 5.0% or more than 10.0%. The real deciding factor of whether or not a cap rate is good is if you are comfortable with it.

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Limitations Of Capitalization Rate

While a capitalization rate calculator can give investors a good idea of a property’s expected rate of return, the formula isn’t perfect. As a result, investors should never use the cap rate alone; it has several limitations that need to be accounted for, not the least of which include the following:

• Doesn’t Account For Financing: A cap rate calculator for real estate deals only accounts for the relationship between an asset’s income and market value. Therefore, anyone who finances the purchase with a loan will have added costs (like interest) that aren’t factored into the cap rate and impact the return on investment.
• Assumes Income Will Remain Unchanged: Every cap rate calculator assumes the income on an investment property will remain the same. However, every investor will tell you that’s just not the case. Whether changes in gross rent rates, expenses, or vacancy rates, cap rates neglect to account for future shifts that can drastically change the rate of return.
• Ignores Changes In Home Values: The cap rate completely ignores that the value of a property can appreciate or depreciate. That means the formula for the same property will differ in the face of appreciation and depreciation, even after just a short period. Commercial real estate values will eventually fluctuate and change the initial cap rate, but none of that is accounted for in the initial calculation.
• Doesn’t Factor In Taxes: While the cap rate will include the property's total market value, it will not factor in future taxes. Property taxes, for example, will eventually be added to the cost of buying and owning the home. Still, the cap rate calculation doesn’t account for the future expense (even though it can impact the property’s rate of return).
• Neglects Location: Different locations have become synonymous with different rates of return, which means the cap rate doesn’t translate equally from one real estate market to the other.

A cap rate is an excellent tool for gaining insight into a subject property’s potential. However, it is crucial to understand that cap rates are extremely limited. Instead of providing a definitive rate of return that investors can bank on, the cap rate is more of a “ballpark” estimate that leaves a lot of important information out. Therefore, additional research and analysis are required to make a well-informed investment decision.

Capitalization Rate: Frequently Asked Questions (FAQ)

Cap rates are essential to understand, but far too many inexperienced investors find them to be a source of confusion instead of a valuable tool.

As a result, we’ve created the following section to shed some light on some of the most frequently asked questions about cap rates.

What Is The Ideal Cap Rate For An Investment Property?

Generally, a cap rate between 4% to 10% is considered good, but higher rates may indicate higher risk and potential return. However, the ideal cap rate varies depending on the market and investment goals. It's essential to align the cap rate with your risk tolerance and the specific market conditions of the area where the property is located.

Can Cap Rate Calculators Be Used For Commercial Properties?

Yes, our cap rate calculator is highly effective for commercial properties. It can provide a quick and reliable way to assess the potential return on investment, considering the unique financial aspects of commercial real estate, such as longer lease agreements and different types of operating expenses.

How Often Should I Re-evaluate The Cap Rate Of A Property?

It's advisable to re-evaluate the cap rate annually or whenever there are significant changes in the property's income, expenses, or the local real estate market. Regular reassessment helps in keeping track of the property's performance and making timely decisions in line with market trends.

How Do You Account For Variable Expenses In Cap Rate Calculations?

To account for variable expenses in Cap Rate calculations, estimate an average annual cost based on historical data and foreseeable changes. Include these estimates in the operating expenses before calculating the NOI. This approach helps in achieving a more accurate and realistic Cap Rate that reflects potential fluctuations in expenses.

Does Cap Rate Include Mortgage?

The cap rate does not include monthly mortgage payments. A cap rate calculator leaves out mortgage payments because it doesn’t account for debt-related expenses. Instead of focusing on the means of acquisition, the cap rate focuses on the property relative to its net operating income.

Do Cap Rates Rise With Interest Rates?

Cap rates typically do not rise with interest rates because they do not account for the loan used to acquire the property.

According to Steve Gilbert, Director of Applied Modeling and Analytics for J.P. Morgan Investment Banking, “While cap rates and interest rates are loosely correlated, and rapidly rising interest rates would generally imply upward pressure on cap rates, the change in cap rates would typically be mitigated by rent growth prospects, local economic outlook, neighborhood demand/supply balance and other idiosyncratic factors for a specific property or investor.”

What Does A 7.5% Cap Rate Mean?

The cap rate, expressed as a percentage, estimates a property’s annual net income relative to the home’s market value. Therefore, a 7.5% cap rate suggests an investor can expect to make about 7.5% of the home’s purchase price in annual net operating income.

Final Thoughts On Cap Rate Calculators

Understanding cap rates is an integral part of real estate investing. It offers you a quick glance at a property's income potential in relation to its market value. By leveraging our cap rate calculator, you can evaluate property valuations, compare various investment options, and assess the associated risk.

However, while knowing how to calculate capitalization rate is vital, it's equally crucial to recognize its limitations. Cap rates shouldn't be the only metric used to scrutinize a potential deal; such a singular view can be restrictive. It's important to supplement your comprehensive analysis with cap rates to gain a more accurate and holistic understanding of the property at hand.

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*Disclosure: Real Estate Skills is not a law firm, and the information contained here does not constitute legal advice. You should consult with an attorney before making any legal conclusions. The information presented here is educational in nature. All investments involve risks, and the past performance of an investment, industry, sector, and/or market does not guarantee future returns or results. Investors are responsible for any investment decision they make. Such decisions should be based on an evaluation of their financial situation, investment objectives, risk tolerance, and liquidity needs.