What Is Cap Rate and How Do You Calculate It?
When you’re investing in a property, you always want to make sure it’s a safe investment. We measure the safety of an investment by how much capital it’s going to generate, and how consistently it will generate that capital.
There’s always an element of risk, but fortunately, there’s a very safe and easy way for you to assess a property’s value before you buy it.
I know – assessing a property’s value sounds incredibly difficult, confusing, and like it’s a job for the pros. But it’s not as confusing as you might think. Using a “cap rate” calculation you can determine the value of a property in minutes.
What is a Cap Rate?
A cap rate is a formula that tells you the rate of return you can expect from a property.
Essentially, a cap rate can tell you if a commercial property is a good investment (i.e. if you’re more likely to make money). Using a cap rate also allows you to compare the potential income of two similar properties because it takes all the different elements into account and compares how they’ll come together to impact ROI.
How Do You Calculate a Cap Rate?
Calculating a cap rate sounds complex, but it’s actually fairly simple.
Your cap rate is the net operating income divided by the property value (Cap Rate = Net Operating Income / Current Property Value).
This is calculated annually. If you’re not a numbers person, this may sound confusing, so let’s break it down together.
1) First, determine the Net Operating Income (NOI) which is:
• The Gross Rental Income (minus) the Operating Expenses
2) Determine the Current Property Value.
3) Use the formula above (Net Operating Income / Current Property Value).
You can also take occupancy rate into consideration. If you’d like to add this, multiply the occupancy rate by the gross rental income before step one.
Still confused? Let’s walk through an example I found on Fit Small Business comparing two properties:
Property Value: $850,000
Occupancy Rate: 98%
Gross Rental Income: $96,000
Operating Expenses: $38,000
Property Value: $700,000
Occupancy Rate: 98%
Gross Rental Income: $72,000
Operating Expenses: $22,000
First, multiply the occupancy rate by the gross rental income:
Property A: 98% x $96,000 = $94,040
Property B: 98% x $72,000 = $70,560
Now, subtract the operating expenses to get your Net Operating Income (NOI):
Property A: 94,080 - $38,000 = 56,080
Property B: $70,560 - $22,000 = $48,560
Finally, divide the NOI by the property value to get the cap rate:
Property A: $56,080 / $850,000 = 0.066 x 100 = 6.6%
Property B: $48,560 / $700,000 = 0.069 x 100 = 6.9%
So the cap rates for these two properties are 6.6% and 6.9%, respectively. So Property A has a slightly better cap rate than Property B. However, since the rates are so similar and Property B is less expensive, many investors would consider Property B the safer investment.
What Else Should You Consider?
Cap rate give you a good look at the value of a property, but it doesn’t account for everything that affects the value. It doesn’t consider location, features, or the quality of a building. I highly recommend that you do research (start here) outside of the cap rate so you can be confident in your investment’s value.