What is Cap Rate and How to Calculate It

If you’re considering an income property, it only makes sense to learn its value. Failing to calculate this correctly could result in a significant loss of your company’s investment capital. That’s why it’s important to understand what cap rate is, and how to calculate it.

What is Cap Rate?

Cap (capitalization) rate is a number that indicates the amount of return you can expect from an investment property. There are at least two ways to estimate the ROI of your property.

The first option is to use the amount of income that your property is expected to generate with expenses deducted, and the current market value of the property.

Another version uses purchase price in place of current market value. Just know that this cap rate calculation is not very popular. The purchase price can lead to some very inaccurate results. For example, if you bought that estate decades ago, the current real estate prices are likely very much different. The same applies to a property that was purchased for a significant amount of money years ago but lost its value afterward due to deterioration.

Why You Need to Keep an Eye On Your Cap Rate

As a property manager, you’ll always want to find new ways of maximizing your portfolio of well-performing assets. Knowing your cap rate will help you to assess whether a property you are considering is likely to meet your income requirements.

By calculating the cap rate, you also force yourself to consider both the expenses of owning property along with the income potential. Ultimately, this helps you to make better purchasing decisions since you can estimate your returns before dropping any cash on some new real estate.

You can also use this formula to compare the potential income rates of several properties at once. That’s useful as in most cases, you’ll be benchmarking one property against another in any case. Cap rate lets you put a dollar number on each option.

Further, you have to understand your operating costs and operating income to calculate your cap rate. This can be a good thing, especially for those who are newer to investing in real estate. You’ll be forced to consider what your potential expenses will be as part of owning a particular property. That’s something you should be considering anyway.

How to Calculate Your Cap Rate

As mentioned already, you have two options to calculate your cap rate. In this post, we’ll use the first, more popular and accurate, cap rate formula. It’s pretty simple and straightforward, meaning that you can simply ‘plugin’ the relevant numbers, and get your result.

So let, dig into that.

First, Get The Relevant Variables

You’ll need to start with the right numbers before you can calculate your capitalization rate. The first of these is the net income. That’s your gross income with expenses such as taxes, maintenance, and insurance taken out. For this calculation imagine the following:

Net Income = Gross Income ($50,000) – Maintenance ($10,000) – Taxes ($5,000) – Insurance ($2,000).

The Net Income equals $33,000.

Now, you need to figure out your current market value. Let’s say that’s $125,000.

That’s all you need! Let’s put the numbers together using this easy cap rate formula.

Cap Rate = Net Income/Current Market Value.

In this case, that’s Cap Rate = 33,000/125,000. That makes the cap rate: .264.

Don’t forget that there is another version of the calculation that substitutes the current market value with the purchase price. However, that’s the less popular of the two for reasons mentioned above.

Calculating Cap Rate in The Real World

There’s only one problem with the formula above. You won’t know all of the variables ahead of time if you are trying to calculate the capitalization rate for a property you haven’t purchased yet.

Instead, you’ll need to do some investigating in order to come up with numbers that give you a reasonable approximation. One thing you can do is find the sales prices and net incomes for comparable prices in the same area.

You can also lookup numbers on tax rates, and insurance costs with a bit of research effort. Try the local assessors’ website for tax information, for example. Lastly, browse recent property sales prices through various real estate websites:

Cap Rate as a Sales Tool

Finally, if you plan on selling a property, you can use the capitalization rate to help determine the optimal sales price for your unit. Simply take your net operating income, and divide that by the cap rate. Based on the example. That would be 33,000/.264. That returns your current market value of $125K.

Final Thoughts

Once you have the numbers you need, you can calculate the cap rate quickly and easily. Don’t miss the chance to learn as much as you can about the income potential of any property to make educated investment choices!

Photo by Dahl House Design 

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