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 a 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,
Explanation
The calculation of 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 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.
Example #1
Let us assume that an investor is planning to buy a real estate property. Now, the investor intends to take the decision on the basis of 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:
Now let us do the calculation of cap rate for the respective properties,
Property A
So, Cap Rate for property A = ($150,000 – $15,000) ÷ $1,500,000
= 9%
Property B
So, Cap rate for property B = ($200,000 – $40,000) * 100% ÷ $4,500,000
= 3.56%
Property C
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.
Now, based on the above information, we have calculated the following values which will be further use in calculation of cap rate.
Annual Gross Revenue-
Annual Expense
Net Operating Income
In the below-given template, we have used the calculation of cap rate equation.
So the calculation will be –
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.
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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 the higher return. Moreover, it can also show the trend for 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 on the basis of 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 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 Cap Rate Formula Calculator with a downloadable excel template. You can learn more about financial analysis from the following articles –
