A Guide to Understanding Cap Rate Formula in Real Estate

Are you ready to invest in real estate? You need the right tools and knowledge to help you make smart, informed decisions. 

One of the tools in the investor’s arsenal is the capitalization rate, or “cap rate” for short. Think of it as your real estate investment’s financial compass, pointing you toward its potential profitability.

In this comprehensive guide, we’ll unravel the cap rate formula, show you a real-world example of how to use it, and empower you to navigate real estate investing with confidence.

What is the capitalization rate?

The capitalization rate is a quick way to estimate the potential return on a real estate investment property. It’s a financial ratio used to assess the potential rate of return on an investment property as a function of its net operating income (NOI) and current market value (CMV).

It’s like figuring out what percentage of your initial investment you might earn back each year in cash from the property’s income, with certain assumptions we’ll get to later in the post.

Why does the cap rate matter?

The capitalization rate is a powerful tool for investors to compare and evaluate the potential profitability of various real estate investments and estimate their future cash flow. It serves as a financial metric for assessing an investment’s attractiveness and making well-informed decisions in the following ways:

Quick value assessment for investment decision-making

The cap rate provides a snapshot of a property’s value relative to its income-generating potential. By calculating the cap rate for different properties, real estate investors can compare their potential returns and select the most profitable opportunities aligned with their financial goals.

Risk vs. reward

Higher cap rates often indicate higher potential returns but also might suggest greater risk associated with the investment, such as properties in less desirable locations or requiring significant repairs.

Market analysis

Comparing cap rates across different markets and property types helps investors identify trends and opportunities in specific areas or asset classes.

The cap rate formula and how to use it

Now to the heart of the matter—the cap rate formula. The formula is a simple ratio between the net operating income and the investment’s current market value:

Capitalization Rate = [Net Operating Income (NOI)] / [Current Market Value (CMV)]

Let’s break down each of the formula’s components:

Assessing net operating income (NOI)

The net operating income (NOI) represents the annual income or revenue generated by an investment asset (like a rental property) after deducting its operating expenses, which do not include mortgage payments or income taxes.

NOI = Total Revenue – Operating Expenses

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Step-by-step calculation of NOI

1. Calculate total revenue: Add up all the property’s income sources, such as rental income, laundry income, parking fees, and any other miscellaneous income.

2. Calculate operating expenses: Identify and sum up all reasonable and necessary expenses incurred to operate and maintain the property. These typically include:

• Property management fees
• Maintenance and repairs.
• Property insurance.
• Property taxes.
• Other expenses, including utilities (if not paid by tenants), landscaping, etc.

3. Apply the NOI formula: Subtract Operating Expenses from Total Revenue. The result is the property’s NOI.

Assessing current market value (CMV)

The current market value (CMV) is the estimated price at which an asset, like an investment property, would likely sell in the current market under normal conditions. It reflects the property’s fair market value based on recent comparable sales, market trends, and its condition and features.

How to find a property’s CMV

There are several ways to find the CMV of an investment property:

• Comparative market analysis (CMA): A real estate agent or appraiser can conduct a CMA by analyzing recent sales of similar properties in the area. This involves using the best market research tools to gather data on comparable properties, such as their size, location, amenities, and sale prices. These tools can provide valuable insights into the current market trends and help determine a property’s fair market value.
• Online valuation tools: Several online platforms offer automated property valuations based on algorithms and market data.
• Professional appraisal: For the most accurate assessment, consider hiring a licensed appraiser. They’ll thoroughly evaluate the property and provide a formal appraisal report.

A more general cap rate formula

Combining the formulas for NOI and cap rate, we can arrive at a more general formula for calculating the cap rate:

Cap Rate = (Total Revenue – Operating Expenses) / (Current Market Value)

This formula allows you to calculate the cap rate directly by bypassing the NOI calculation.

Step-by-step calculation example: Using the cap rate formula for a residential investment property

Let’s illustrate the cap rate calculation in real estate with an example:

Scenario

• You’re considering investing in a single-family rental property with a selling price of $400,000, which is near the national median home price, according to Bankrate.
• For monthly rental income, we’ll use the average rent price for single-family homes in the US of $2,600, according to CBS.
• We’ll assume a property tax of 0.87% (national average), a monthly property insurance premium of $200, estimated maintenance and repair costs of 2.5%, and a property management fee that consumes 10% of the rental income.

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Step #1: Calculate the total revenue

Since this is a residential rental property, the only source of revenue is the monthly rent.

Total Revenue = ($2,600/mo) * (12 mo) = $31,200

Step #2: Calculate operating expenses

The following table breaks down the rental property’s operating expenses based on the abovementioned assumptions.

Expense Type	Average Rate	Estimated Annual Cost
Property Taxes	0.87%	$3,480
Property Insurance	$200/mo	$2,400
Maintenance & Repairs	2.5%(1%-4% of property value)	$10,000
Property Management Fees	10%(8%-12% of rent)	$3,120
Other Expenses	—	$1,000
Total Operating Expenses		$20,000

Step #3: Calculate NOI

NOI = (Total Revenue) – (Operating Expenses) = ($31,200) – ($20,000) = $11,200

Step #4: Calculate the capitalization rate

Capitalization Rate = NOI / CMV = ($11,200) / ($400,000) = 0.028 or 2.8%

It’s important to note these values are based on national averages and will vary significantly depending on location and property.

For example, the average purchase price for a home in the US varies from $202,000 in West Virginia to $1,170,000 in Hawaii. The same goes for commercial properties where purchase prices per square foot vary significantly, as do rental income, tax rates, and other factors.

How to interpret your cap rate

In our example, the calculated cap rate of 2.8% means that the property could generate an annual return of $2,800 for every $100,000 you invest, assuming the current income and expenses remain stable and property prices don’t change.

You should take this with a grain of salt since these assumptions rarely hold in the real estate market. Instead of interpreting this figure as the actual return you can expect to receive, it’s better to use it as a benchmark against which you, as a real estate investor, can compare similar properties in the market and evaluate their investment potential.

High or low? What a good capitalization rate looks like

The ideal cap rate varies depending on several factors, including asset class (property type), location, market conditions, risk tolerance, and return expectations.

A higher cap rate suggests a higher potential return on your investment but is also a measure of risk. Factors like bad location or market conditions (high risk) may lead to lower property value, increasing the cap rate.

On the other hand, a lower cap rate often implies a lower potential return, but also a lower risk. 

Furthermore, cap rates are typically lower than 12%, depend on property type (see image below), and vary from quarter to quarter.

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It’s crucial to compare cap rates to similar properties in the same area to gauge whether a particular cap rate is considered good.

Limitations of the cap rate formula

The cap rate formula has some limitations as a tool in real estate investment analysis because it:

• Oversimplifies investment value by not accounting for income tax, interest on debt, capital spending, and amortization.
• Assumes that the property’s income and expenses will remain constant, which is usually untrue.
• Ignores financing costs like mortgage interest rates, loan terms, and others.
• Doesn’t account for future appreciation or depreciation.

While the cap rate is a valuable starting point, smart investors also consider other financial metrics, such as the return on investment (ROI), cash-on-cash return, and internal rate of return (IRR), to understand a property’s potential better.

Cap rate vs. return on investment (ROI)

While the cap rate provides a quick snapshot of a property’s potential value, the return on investment offers a more comprehensive view of an investment’s profitability by considering the total return over the holding period, including any appreciation or depreciation in the property’s value.

When to Use Each:

• Cap rate: Ideal for quickly comparing the potential returns of different properties and evaluating their current income-generating capabilities.
• ROI: More suitable for assessing an investment’s overall profitability over its entire holding period, considering both income and potential capital gains.

One of many tools

The cap rate is just one of many tools in your real estate investment toolbox. It’s a financial metric calculated as the ratio between a property’s NOI and CMV that quickly assesses its value and potential annual returns.

A well-rounded approach, combining financial metrics like the cap rate with careful analysis and strategic planning, is key to real estate investing success.

RentRedi’s all-in-one property management software allows you to streamline your operations, maximize your returns, and easily track your properties’ cap rates to achieve your investment goals.