Cap Rate Formula

What is Cap Rate Formula?

The formula for Cap rate or Capitalization rate is very simple, and it is calculated by dividing the net operating income by the current market value of the asset and is expressed in terms of percentage. It is used by the investors to evaluate real estate investment based on the return of a one year period. It is basically used to help decide whether a property is a good deal.

Mathematically, Cap Rate Formula is represented as,

Cap Rate Formula = Net Operating Income / Current Market Value of The Asset

Cap-Rate-Formula

Explanation

The calculation can be done in the following three simple steps:

  • Step 1: Firstly, the rental income of the real estate property has to be estimated correctly. Based on that, the calculation of the net operating income is done, which is basically the annual income generated by the real estate property minus all the expenses that are incurred during the operations, which include tasks like managing the property, paying taxes, insurance, etc.
  • Step 2: Secondly, the current market value of the property has to be assessed properly, preferably by a reputed valuation professional. The current market value of the property is its worth in the marketplace.
  • Step 3: Finally, the calculation of the cap rate can be done by dividing the net operating income by the current market value of the investment property.

Examples of Cap Rate Formula (with Excel Template)

Let us see some simple to an advanced example to understand it better.

You can download this Cap Rate Formula Excel Template here – Cap Rate Formula Excel Template

Example #1

Let us assume that an investor is planning to buy a real estate property. Now, the investor intends to make the decision based on the cap rate, which is an effective metric in the evaluation of real estate properties. The investor finds three properties with their respective annual income, expenses, and market values, as mentioned below:

cap rate formula example 1.1

Now let us do the calculation of the cap rate for the respective properties,

Property A

cap rate formula example 1.2

So, Cap Rate for property A = ($150,000 – $15,000) ÷ $1,500,000

= 9%

Property B

cap rate formula example 1.3

So, Cap rate for property B = ($200,000 – $40,000) * 100% ÷ $4,500,000

= 3.56%

Property C

cap rate formula example 1.4

So, Cap rate for property C = ($300,000 – $50,000) * 100% ÷ $2,500,000

= 10.00%

Therefore, the investor should buy property C since it offers the highest cap rate of 10%.

Example #2

Let us assume that there is another investor who wants to buy a real estate property, and the investor has the below-mentioned information. The investor will invest in the property only if the cap rate is 10% or higher.

cap rate formula example 2.1

Now, based on the above information, we have calculated the following values, which will be further use in the calculation of the cap rate.

Annual Gross Revenue-

cap rate formula example 2.2

Annual Expense

cap rate formula example 2.3

Net Operating Income

cap rate formula example 2.4

In the below-given template, we have used the calculation of the cap rate equation.

cap rate formula example 2.5

So the calculation will be –

cap rate formula example 2.6

Now, since the calculated cap rate is higher than the target rate (10%) of the investor, therefore, the investor can invest in the concerned real estate property. Based on the calculated rate, it can also be inferred that the entire investment will be recovered in = 100.00% ÷ 12.38% = 8.08 years

Cap Rate Formula Calculator

You can use the following calculator.

Net Operating Income
Current Market Value of the Asset
Cap Rate Formula
 

Cap Rate Formula =
Net Operating Income
=
Current Market Value of the Asset
0
= 0
0

 

Relevance and Use

  • The principal use of a cap rate is to distinguish among different real estate investment opportunities. Let us assume that a real estate investment offers around 4% in return while another property has a cap of around 8%. Then, the investor is most likely to focus on the property with a higher return. Moreover, it can also show the trend for the property, which will indicate if there is a need for an adjustment based on the estimated rental income.
  • From a real estate investor’s point of view, a cap is an essential tool as it enables an investor to evaluate a real estate property based on its current market value and its net operating income. It helps at arriving at the initial return on an investment property.
  • For an investor, a rising cap rate for a property can be indicative of a rise in rental income vis-à-vis the price of the property. On the other hand, the investor can see a fall in this rate as a sign of lower rental income relative to the price of the property. As such, it can be a critical factor for an investor to decide if the property is worth buying or not.
  • Further, it can also be an indicator of the amount of time a real estate will take to recover the entire investment in that real estate property. Let us assume that a property offers a cap rate of around 10% cap, which means that it will take 10 years (= 100% ÷ 10%) for the investor to recover the entire investment.

Recommended Articles

This article has been a guide to Cap Rate Formula. Here we discuss its practical examples to understand the Cap Rate Equation. Here we also provide you with a Cap Rate Formula Calculator with a downloadable excel template. You can learn more about financial analysis from the following articles –

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