Cap Rate Formula : How to Calculate Cap Rate
The cap rate formula is simple : Divide net operating income ( NOI ) by the property value ( or the purchase price ).
Cap Rate = Property ’ s Net Operating Income / Property Value ( or Purchase Price )
We can find net operating income by subtracting the property ’ s annual expenses from its annual gross revenue . Expenses will include things like operating expenses , management , taxes , and anything else you must pay to keep the property running .
Careful though — debt payments , capital expenditures , and depreciation deductions are NOT included in the calculation . This is because we are trying to get a sense of the property ’ s performance irrespective of any mortgage arrangements , improvements we might make or depreciation schedule that may be selected .
For revenue or cashflow , you ’ ll simply plug in what tenants currently pay in rent ( total rental income ), as well as any other sources of income ( Ex : a laundromat or a parking garage ).
Should I Use Market Value or Purchase Price as my Denominator ?
For the bottom of our capitalization rate fraction , market value is generally preferred . A purchase price can be used if the property has sold recently , but using a purchase price from ten years ago won ’ t result in a meaningful cap rate . If we are considering purchasing the property , it would be very useful to plug in various possible purchase prices to see what rate we ’ ll achieve . This can be a helpful guide when determining an acceptable offering price .
Here are some examples :
Suppose you ’ re an investor considering buying Property A . The property is valued at $ 1,000,000 and generates an NOI of $ 50,000 annually . Plugging this into our equation we get :
Cap Rate = $ 50,000 /$ 1,000,000 = 5 %
Suppose you compare Property A to a similar property that is valued at $ 1,000,000 and has an NOI of $ 60,000 . This gives us a Cap Rate of 6 %. If all else between Properties A and B is equal , the higher cap property is the better buy .
Investors can also think of cap rate as a measure of their rate of return on their investment . For example , with the 5 % rate , an investor earns 5 % of their purchase price annually and will recoup the purchase price in the 20 years .
What Does a High Cap Rate Mean ? What About a Low Cap Rate ?
There ’ s a lot more to cap rates than “ higher cap = better investment .” No two properties are created equal , and in practice , properties with a very high cap rate often turn out to be higher risk as well .
Let ’ s think about our capitalization rate equation again , and what factors might contribute to driving it higher . We ’ ll look at Property A again , which had an NOI of $ 50,000 , a property value of $ 1,000,000 , and a 5 % cap rate .
If we want to raise our rate by changing NOI , then NOI will have to increase . This could be accomplished by increasing revenue , or lowering expenses . In either case , increased NOI is typically a good thing .
Now , let ’ s say we want to raise our cap rate by modifying property value . In this case , property value will have to decrease . A decrease in property value could be driven by several things , including the worsening reputation of a location or the revelation of some costly deferred maintenance .
Image by Gerd Altmann from Pixabay
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