What is Cap Rate Formula?
The formula for the Cap Rate or Capitalization Rate is straightforward. One may calculate by dividing the net operating income by the asset’s current market value and percentage. Investors use it to evaluate real estate investment based on one year’s return and to help decide whether a property is a good deal.
According to analysts and experts, a good cap rate ranges between 5%-10%. It is important to note that a cap rate of 4% or lesser would indicate a lower risk of investment. However, it would take a longer time frame to recuperate the profits from the investment.
Table of contents
- The Cap Rate or Capitalization Rate formula is straightforward. The calculation is done by dividing the net operating income by the asset’s current market value and percentage. Investors utilize it to determine real estate investment based on one year’s return and decide if a property is a good deal.
- This principle distinguishes various real estate investment opportunities. In addition, it shows the property trend that indicates if there is a need for an adjustment based on the estimated rental income.
- For an investor, a rising Cap Rate for property shows a rise in rental income vis-à-vis the property’s price. Conversely, the investor may experience a decline in this Rate as lower rental income relative to the property’s worth.
Cap Rate Formula Explained
The cap rate formula indicates the yield of a property for a period of one calendar year. It is calculated by dividing the net operating income by the value of the property. It is pivotal in fixing rental agreements, understanding the value of the property in a particular vicinity, and making setting aside investments easier because data about the income that has been generated from the property is made easier to avail.
You can do the calculation in the following three simple steps: –
- Firstly, one must estimate the real estate property’s rental income correctly. Based on that, the net operating income calculation Net Operating Income CalculationNet Operating Income (NOI) is a measure of profitability representing the amount earned from its core operations by deducting operating expenses from operating revenue. It excludes non-operating costs such as loss on sale of a capital asset, interest, tax expenses. is done, which is the annual income generated by the real estate property minus all the expenses incurred during the operations, which include tasks like managing the property, paying taxes, insurance, etc.
- Secondly, the property’s current market value must be appropriately assessed, preferably by a reputed valuation professional. The current market value of the property is its worth in the marketplace.
- Finally, one can calculate the Cap Rate by dividing the net operating income by the current market value of the investment propertyThe Investment PropertyInvestment property refers to the real estate acquired to earn returns on the investment through rental income, royalties, dividends or future appreciation, usually in the name of an individual investor, a group of investors or an investment company for a short-term or a long-term investment..
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Mathematically, one may represent the Cap Rate formula as:
Cap Rate Formula = Net Operating Income / Current Market Value of The Asset
Let us understand the concept of market cap rate formula with the help of a couple of examples as discussed below.
Let us assume that an investor plans to buy a real estate property. The investor intends to decide on an effective metric for evaluating real estate properties based on the Cap Rate. The investor finds three properties with their respective annual income, expenses, and market values, as mentioned below: –
|Property||Annual Income||Annual Expense||Market Value|
Now, let us do the calculation of the Cap Rate for the respective properties,
So, Cap Rate for property A = ($150,000 – $15,000) ÷ $1,500,000
So, Cap Rate for property B = ($200,000 – $40,000) * 100% ÷ $4,500,000
So, Cap Rate for property C = ($300,000 – $50,000) * 100% ÷ $2,500,000
Therefore, the investor should buy property C since it offers the highest Cap Rate of 10%.
Let us assume that another investor 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.
We have calculated the following values based on the above information, which we may use further to calculate the Cap Rate.
Annual Gross Revenue-
Net Operating Income
In the below-given template, we have used the calculation of the Cap Rate equation.
So the calculation will be –
Now, investors can invest in the concerned real estate property since the calculated cap rate is higher than the investor’s target rate (10%). Therefore, based on the calculated rate, one can infer that they will recover the entire investment in = 100.00% ÷ 12.38% = 8.08 years.
A calculator to calculate the market cap rate formula is provided below for the perusal of the reader.
|Cap Rate Formula =||
Relevance and Uses
Let us understand the relevance and uses of the cap rate formula through the explanation below.
- The principal use of a Cap Rate is to distinguish 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 about 8%. Then, the investor will most likely 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 net operating income. It helps in arriving at the initial return on an investment property.
- For an investor, a rising Cap Rate for a property can indicate a rise in rental income vis-à-vis the property’s price. On the other hand, the investor can see a fall in this rate as lower rental income relative to the property’s price. It can be a critical factor for an investor to decide whether the property is worth buying.
- Further, it can also indicate the 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%, which means it will take ten years (= 100% ÷ 10%) for the investor to recover the entire investment.
Frequently Asked Questions (FAQs)
Analysts consider around 5% to 10% Cap Rate, and 4% shows a lower risk but a longer timeline of recovering the investment. Essentially, one must rely on the Cap Rate as other factors, such as local property features, also must be considered.
Cap Rates move intently with both variables. Therefore, economically and statistically, actual interest rates increase cap rates.
Usually, a high Cap Rate means a higher risk level, and a lower Cap Rate refers to lower returns but lower risk.
Cap Rate and ROI are different. The Cap Rate refers to the anticipated return based on the property value. In comparison, the ROI refers to the cash investment return, not the market value.
This article is a guide to the Cap Rate Formula. Here, we explain cap rate examples to understand the cap rate equation, calculator, and Excel template. You can learn more about financial analysis from the following articles: –
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