If you’re new to property investing, the sheer amount of real estate terminology can be confusing and intimidating. The capitalization rate, more commonly known as “cap rate,” is a tool that every real estate investor should have in their repertoire. Cap rate is a comparative metric that real estate investors can use to calculate the expected rate of return from an investment property.
In other words, the cap rate measures the annual yield generated by a leveraged or non-leveraged property. If you purchase your property upfront, the cap rate can be an accurate representation of a real estate asset’s intrinsic rate of return. This means you can use a cap rate to quantify and compare your risk exposure across different investment properties. If you’ve purchased a real estate asset via external financing, the cap rate can also be used to approximate a repayment timeline.
How to Calculate Cap Rate?
The shorthand formula for calculating cap rate is:
Cap rate = Net Operating Income/Current Market Value
We’ve broken down what both of these components represent:
- Net operating income (NOI): A property’s NOI is calculated by subtracting the total operating expenses from the property’s total revenue output.
- Current market value: The current market value is the price, as determined by day-to-day market conditions, of a real estate asset on the property marketplace. The current market value of a property is usually derived from professional appraiser evaluations.
If you’re still having trouble understanding how to calculate cap rate, we’ve created a basic scenario and example calculation for you to follow:
Take a real estate investor that owns a house with a current market value of $900,000. The investor also spends a further $5,000 every year on maintenance and housing taxes. If the house generates $80,000 in rent every year, the NOI for the property would be $75,000.
Therefore, in this example, the cap rate = $75,000/$900,000 = 8.33%
Remember, this is just a basic example. In reality, the process of calculating the cap rate is often far more complex and time-consuming. To get a more complete picture of your potential rate of return, we’ve included our own Financial Model spreadsheet. You can use this tool to analyze prospective investment properties and calculate the cap rate, cash-on-cash returns, and much more. To use this tool yourself, follow this link, click on “File” and then “Make a Copy”.
Understanding and Interpreting Cap Rate
Once you have grasped the underlying principles of cap rate, you can quickly draw basic conclusions from the output information. Simply put, a higher cap rate suggests a lower rate of return, indicating greater risk exposure. Similarly, a lower cap rate denotes a safer investment and a higher rate of return.
If you’re using cap rate to evaluate prospective real estate investments, you need to consider future projections for the revenue and market value of each property. This is because cap rate calculations will vary significantly during turbulent market conditions or periods of low rental demand. Knowing what cap rate is suitable for your investment position requires a deeper understanding of several key secondary variables. Here are the two most influential cap rate modifiers you need to be aware of:
- Property location: Location is often cited as an early indicator of a successful real estate investment. The location-specific factors that most affect market value, and consequently cap rate, are contingent on an area’s employment rate, education level, regional industries, and population density.
- Interest rates: Even if there is no change in local market conditions, your property’s cap rate will still change if the Federal Reserve sets a new interest rate. When the Federal Reserve hikes interest rates, it increases the cost of servicing property debt, thereby reducing the annual income from your real estate asset and decreasing the overall value of the property.
Still Unsure? Find Out More By Connecting With a Real Estate Agent!
If you’re considering purchasing a commercial property and want to know more about cap rates and other valuation methods, reaching out to a local Clever Partner Agent is a good first step. Contact Clever if you want to connect with an experienced real estate agent that specializes in real estate investing specific to your target market. The Clever Partner Agent Network is made up of top-rated, full-service agents from major real estate brands and brokerages (including RE/MAX, Century 21, Keller Williams).