How to Figure Cap Rate

Real estate investors rely upon a variety of type’s information when negotiating for income producing properties ‐ for instance, the desirability of the property's current location and/or any prospective changes in the neighborhood are two common factors. One crucial piece of information that helps investors make their decision is called the capitalization rate (or "cap rate"). The cap rate (expressed as the ratio of the property's net income to its purchase price) allows investors to compare properties by evaluating a rate of return on the investment made in the property. See Step 1 below to calculate the cap rate for your home!

Calculating Cap Rate

#1  Calculate the yearly gross income of the investment property.
The gross income of a piece of investment property will mainly be in terms of rent rolls. In other
words, when a real estate investor buys a home, s/he usually makes money from it primarily by
renting it out to tenants. However, this isn't the sole possible source of income - miscellaneous
income can also accrue from the property in the form of coin operated vending or washing
machines, etc.

For example, let's say that we've just purchased a house we intend to rent to tenants at a
rate of $750/month. At this rate, we can expect to make 750 × 12 = $9,000 per year in
gross income from the property.

#2 Subtract the operating expenses associated with the property from the gross income.
Any piece of real estate comes with operating costs. Usually, these are in the form of
maintenance, insurance, taxes, and property management. Use accurate estimates for these
numbers and subtract them from the gross income you found above. This will find the property's
net income.

For example, let's say that, after having our rental property appraised, we find that we can
expect to pay $900 in property management, $450 in maintenance, $710 in taxes, and
$650 in insurance per year for our property. 9,000 - 900 - 450 - 710 - 650 = $6,290, our
property's net income.

 Note that the cap rate doesn't account for the property's business expenses - including the
purchase costs of the property, mortgage payments, fees, etc. Since these items reflect the
investor's standing with the lender and are variable in nature, they adversely affect the
neutral comparison that the cap rate is meant to deliver.

#3 Divide the net income by the property's purchase price. The cap rate is the ratio between the
net income of the property and its original price or capital cost. Cap rate is expressed as a
percentage.

Let's assume we purchased our property for $40,000. Given this information, we now
have everything we need to know to find our cap rate. See below:
o $9000 (gross income)
o -$900 (property management)
o -$450 (maintenance)
o -$710 (taxes)
o -$650 (insurance)
o =$6290 (net income) / $40000 (purchase price) = 0.157 = 15.7% cap rate

Part 2 Using Cap Rates Wisely

#1 Use cap rates to quickly compare similar investment opportunities.
The cap rate basically represents the estimated percent return an investor might make on an all cash
purchase of the property. Because of this, cap rate is good statistic to use when comparing a
potential acquisition to other investment opportunities of a similar nature. Cap rates allow quick,
rough comparisons of the earning potential of investment properties and can help you narrow
down your list of choices.

For example, let's say that we're considering buying two pieces of property in the same
neighborhood. One has a cap rate of 8%, while the other has a cap rate of 13%. This
initial comparison favors the second property - it is expected to generate more money for
each dollar you spend on it.

#2 Don't use cap rate as the sole factor when determining an investment's health.
While cap rates offer the opportunity to make quick, easy comparisons between two or more
pieces of property, they're far from the only factors you should consider. Real estate investment
can be quite tricky - seemingly straightforward investments can be subject to market forces and
unforeseen events beyond the scope of a simple cap rate calculation. At the very least, you'll also
want to consider the growth potential of your property's income as well as any likely changes in
the value of the property itself.

For example, let's say that we buy a piece of property for $1,000,000 and we expect to
make $100,000 per year from it - this gives us a cap rate of 10%. If the local housing
market changes and the value of the property increases to $1,500,000, suddenly, we have
a less-lucrative cap rate of 6.66%. In this case, it may be wise to sell the property and use
the profits to make another investment.

#3 Use the cap rate to justify the income level of the investment property.
If you know the cap rate of properties in the area of your investment property, you can use this
information to determine how much net income your property will need to generate for the
investment to be "worth it". To do this, simply multiply the property's asking price by the cap
rate of similar properties in the area to find your "recommended" net income level. Note that this
is essentially solving the equation (Net income/Asking price) = cap rate for "net income".

 For example, if we bought a property for $400,000 in an area where most similar
properties have about an 8% cap rate, we might find our "recommended" income level by
multiplying 400,000 × .08 = $32,000. This represents the amount of net income the
property would need to generate per year to get an 8% cap rate, so we would set the
rental rates accordingly.

Tips

Always verify the income that is purported to come from the income property, as well as the
expenses, if possible. A condition associated with an offer to purchase the property should
include inspection of the lease agreements to verify the rent rolls. Expenses might be verified by
contacting third party suppliers.

When considering the value of a property, appraisers will look at comparable sales, the
property's replacement value as well as take an income approach to the property. The income
approach considers the required return on equity and debt.

Warnings

The cap rate doesn't reflect future risk. The investor cannot rely on the cap rate to assume that the
property will sustain its current income or value. The property and rents associated with it can
depreciate or appreciate. The expenses can simultaneously rise. The cap rate offers no prediction about
future risk.