How to Calculate a Property’s Cap Rate
When you invest in a rental property, you want to know that it’s an asset to your portfolio. While you can look at the property’s previous net income and general appeal, its cap rate will give you the most information about how the final decision may impact your finances. Use the cap rate calculator below:
What is a Cap Rate?
The term “cap rate,” short for capitalization rate, describes the rate of return on investment (ROI) that certain properties are expected to produce. Investors and landlords can refer to a property’s cap rate to determine how profitable it can be as part of their portfolio.
While a property’s cap rate is not the only important financial figure, it is the easiest one for many potential investors to reference. When you use a cap rate calculator, you can compare two or more properties against one another without having to assess the value of local features.
With that being said, there are no cap rates that are distinctly “good” and none that are particularly “bad.” Instead, the value of a cap rate changes depending on the value of the current real estate market.
Cap Rate’s Determining Factors
There are four figures that tend to hold the largest sway over a property’s cap rate. These include:
- The property’s label (multi-family, single unit, etc.)
- The demographics of interested renters
- The economic status of the city that the property is in
- Local market influences
While you can’t control local market influences, you can understand them before investing in a property. Assess the property you’re interested in, the renters it may appeal to, and projections for the surrounding city.
Match these expectations against the trend of the area market as noted by your cap rate calculator, and you’ll know whether a property is worth your time or not.
How to Calculate Cap Rate for a Rental Property
Cap rates are an indication of a property’s value. With that said, they have some significant overlap with a property’s net operating income. To calculate a property’s cap rate, investors have to estimate what kind of income they could make while keeping said property in their portfolio.
The easiest way to calculate a property’s cap rate is to first establish its net operating income. To do this, you can use a cap rate calculator.
Alternatively, investors can subtract a property’s management and maintenance fees (including taxes and insurance) from the property’s gross income. They can then divide their answer by the property’s purchase price. The resulting number is the lot’s cap rate.
The cap rate equation looks like this:
Gross Income – Property Management Expenses = Net Income
Net Income / Purchase Price = Cap Rate
A property’s cap rate is one of many numbers you need to assess a lot’s overall value. This number does more than let you know how worthwhile a potential investment is, though.
When you use a cap rate calculator, you can more easily:
Track the Market
While the housing market has national trends, its finer points vary from city to city. Tracking those changes takes a lot of dedication, but cap rates can make it easier.
For example, if the cap rates in one part of a city start to skyrocket while others in the same city remain the same, then it might be time to purchase the shifting property.
Alternatively, property that starts to see its cap rate drop over the course of several years may end up becoming a money pit instead of a profitable investment.
Find New Property Opportunities
A consistent cap rate is a good thing. But the great thing about properties with unusual cap rates is that they’re often ripe for re-interpretation. You can negotiate an investment with the owner of these properties on your terms. In turn, the lot’s cap rate can start to come into play while you benefit from the net income it generates.
Rental properties’ cap rates are one indication of their value. You can use a cap rate calculator like the one above to determine whether the property would be an asset to your investment portfolio or not. What’s more, you can use a cap rate to keep an eye on the value of your other properties and ensure their efficient use as the market shifts.