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How to Calculate Cap Rate in 3 Simple Steps

Catherine Hiles • February 14, 2024

Buying a home and calculating cap rate

If you’re considering investing in real estate, you may have heard the term “capitalization rate” or “cap rate.” But what is cap rate, how do you calculate it, and why do you need to know it?

Cap rate is a way of estimating your potential return on your real estate investment.  Learning how to calculate cap rate can help you make smart decisions about your investments.

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Capitalization rate in real estate 

The capitalization rate is a helpful ratio for real estate investors. Investing in real estate can be risky, so it’s wise to look at the cap rate before purchasing a rental property to see how quickly it’ll become profitable.

If you’re considering investing in a new rental property, the cap rate can tell you approximately how long it’ll take to recover your initial investment. For this purpose, you’ll use estimates on rental income and property value since you don’t have solid data to use.

Cap rate can also give you an idea of how well your current rental properties will perform. Calculating cap rates for each property once a year can tell you whether the properties are still profitable or underperforming. In this case, you will calculate the cap rate using the income you receive from rental properties rather than an estimate.

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Why is the cap rate important?

There are several reasons why the cap rate is crucial in real estate investing.

First, if you’re shopping for a rental property and have multiple options, the cap rate can tell you which property will likely offer the highest return on investment. From there, you can decide which property to purchase with relative confidence.

Knowing the cap rate of your existing rental properties can help you decide whether to sell the property, make improvements, raise the rent, or shop around for maintenance professionals with lower fees.

Cap rate doesn’t come into play if you want to become a homeowner since you won’t make rental income from your investment. If you dream of buying and living in your own home, look into the steps for choosing a mortgage lender to help you get on the property ladder.

Cap rate formula explained

Once you understand this formula and its importance, you should learn how to calculate cap rate. The cap rate formula is relatively straightforward:

Capitalization rate = net operating income / current market value

Not sure what all that means? Let’s break it down:

  • Net operating income is the annual income you expect to make from the rental property.
  • Current market value is what you could expect to sell the property for in today’s real estate market.

In general, a cap rate of between 4% and 10% is considered good, though the actual number will depend on how comfortable you are with risk.¹ The higher the cap rate, the more risky the investment is. A seasoned investor may be more comfortable with a higher cap rate than a risk-averse investor or a first-time landlord.

1. Determine net operating income

The first step in figuring out the cap rate is calculating net operating income. To do so, subtract your operating expenses from your gross income.

Your gross income is the money you expect to make yearly from rent. This will be an estimate, though if you already own the property, you can look at past years’ income to make a more informed estimate.

Expenses include real estate taxes, maintenance, property management fees, and insurance.

For example, a rental property that brings in $18,000 in annual income and has total yearly expenses of $5,000 will have a net income of $13,000 ($18,000 gross income – $5,000 expenses = $13,000 net income).

2. Divide by current market value

Once you have determined the net operating income, divide that number by the current market value of the property or asset.

Say the property with $13,000 in net income has a current market value of $150,000. The calculation for this property would be $13,000 / $150,000 = 0.087.

3. Express as a percentage

To determine the cap rate, multiply the above number by 100 to reach a percentage. In this case, the $150,000 property with $13,000 in net income has a cap rate of 8.7% (0.087 x 100, expressed as a percentage).

What impacts cap rates?

Several factors can impact cap rates, making it tricky to compare the cap rates of two or more properties. The main factors that affect the rate are:

  • Market size: Larger housing markets may have lower cap rates because there is more housing inventory and more competition for landlords.
  • Geographic location: Property values and average rent payments vary depending on the property’s location.
  • Asset stability: If the housing market where the property is unstable and the home value is likely to decrease, it can negatively impact the cap rate.
  • Capital liquidity: The amount of capital you invest in the property can affect the cap rate. For example, if you spend a few thousand dollars on renovations and raise the rent accordingly, your net operating income will likely increase.
  • Growth potential: If a property is in an up-and-coming neighborhood where housing prices are rising, the cap rate for the property can change.

Tips for interpreting cap rates

Knowing the cap rate of a property is helpful, but how do you use that number to make decisions? The following tips will help you interpret the cap rate of a property so you can decide whether or not to invest your money.

  • A property with a high market value will likely have a lower cap rate.
  • A higher cap rate means lower return prospects, which makes the property a riskier investment.
  • A lower cap rate means higher return prospects and a safer investment.
  • The cap rate can tell you the number of years it may take to recoup your investment; for example, it would likely take you around 10 years to recover the money invested in a property with a 10% cap rate.
  • Cap rates are based on future income, which means they have a high variance.
  • Although a range of 4% to 10% is considered a “good” cap rate, there is no universally good or bad cap rate. Instead, the investor will determine their comfort level based on their risk tolerance.
  • Cap rates will differ based on income, property valuation, and risk.

Once you understand what the cap rate represents and know your risk tolerance level, you can use this calculation to decide whether or not to invest in a rental property.

A property’s cap rate helps you decide whether or not to invest

Cap rate can help you gauge the potential rate of return on a real estate investment. By understanding how to calculate cap rate for a rental property, you can determine risk and estimate the time it would take to recoup your investment.

But while the cap rate is useful, it’s not the only factor to consider when deciding whether to buy. Cap rate doesn’t consider several important factors, including depreciation and changes in the rental market. It also assumes you’ll pay cash for the property, so if you plan to take out a mortgage loan, the cap rate won’t be much help.

Ready to take the leap and buy a rental home? Learn how to get a mortgage to help make your dream a reality.

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¹ Information from NOLO’s Evaluating Cap Rate: Is That Residential Real Estate Investment Property Worth It? as of January 29, 2024: https://www.nolo.com/legal-encyclopedia/is-that-residential-real-estate-investment-property-worth-it.html

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