The cap rate calculator (short for capitalization rate) is a useful tool as it allows you to quickly get an estimate for how much money the property is expected to make, and how this compares to similar properties in the area.
Cap Rate Calculation Example
Now that you know the basic equations used to calculate the cap rate, below is an example to better illustrate how this is used. First, let’s find our values.
Property Value: $250,000
Total Revenue: Four units x $1,000/month in rent = $48,000/year
Total Expenses:
Property manager salary – $20,000
Cleaning and maintenance – $10,000
Inspection and broker fees – $5,000
Next, let’s calculate NOI. $48,000 (revenue) – $35,000 (expenses) = $13,000. Lastly, we can use this number to calculate the cap rate of the property. $13,000 (NOI)/$250,000 (property value) = .052, or 5.2% cap rate.
What is a Cap Rate Calculator in Real Estate?
A cap rate calculator is used in real estate to find the comparative value of a piece of property in order to determine if it would be a good investment. It’s calculated by balancing the costs of owning and maintaining a property, the property’s market value, and the direct earnings received from that property.
For example, say your client wants to buy a property for $250,000. It currently has four units and receives $1000 in rent from each tenant each month. The current owner paid $35,000/year in inspection fees, maintenance and cleaning fees, and a property manager’s salary. The cap rate calculator takes each of these factors into account to come up with a simple percentage that’s easy to compare across properties.
Cap Rate Calculator Equation
The cap rate calculator equation is actually pretty straightforward, assuming you have all of the necessary information at hand. To calculate the cap rate, you take the Net Operating Income (NOI)/Property Value. You can typically take the asking price as the property value, or there are plenty of online tools available that can provide property value estimates as well.
How to Calculate Net Operating Income (NOI)
Coming up with the NOI for a property is a bit trickier, not because the math is complicated, but because it requires a lot of different numbers upfront. The equation for NOI is Total Revenue – Total Expenses. Total revenue is typically the yearly rent collected from tenants and/or the interest gained over the year. Expenses can include any number of factors such as:
Broker or inspection fees
Pest control
Maintenance
Property management salary
Tenant screening
Property taxes
To find NOI, you add together your revenue sources for the year, then subtract the combined expense amount. You can then use this number to calculate the cap rate. It’s important to note that the cap rate does not take the mortgage payments into account, as this is not a factor that affects the value of the property itself.
Uses for a Rental Property Cap Rate Calculator
There are many ways to use the cap rate when evaluating rental properties. In general, you can think of cap rate as an estimate that’s used to get the lay of the land for real estate investing. Examples of the different uses for a rental property cap rate calculator include:
Understand the value of a property in relation to its neighbors – It stands to reason that properties in similar neighborhoods with similar assets should have similar cap rates. You can use cap rate to identify if a particular property is priced too high or too low, or if there may be underlying issues contributing to an unusual cap rate.
Get a picture of larger market trends in an area – Cap rate is a useful indicator of wider changes in a certain city or area within a city. For example, cap rates changing in a specific neighborhood but staying flat in another similar area can indicate a shift in buyer/renter interest.
Provide useful estimates to clients – For agents, the most important use for a cap rate calculator is to be able to provide accurate estimates to clients for the value of the property, an important factor when making a buying decision.
Identify under-the-radar opportunities – If a property has a conspicuously high cap rate for the area, this could be an indication of mismanagement and an opportunity for a higher return on investment if operations were to be more streamlined and yearly expenses minimized.
Drawbacks of Using a Cap Rate Rental Property Calculator
Though the cap rate is undoubtedly a useful estimate of a property’s value, there are a few limitations to using this metric.
Requires comparisons to be useful – Because cap rates are most often used in comparison to properties of similar sizes, assets, and areas, they require a robust market to actually be valuable. This limits their usability in both smaller markets and for unique properties like tourist attractions, where there typically aren’t enough similar properties to compare to.
Relies on knowing historical costs – Since the cap rate calculation incorporates net operating income, which in turn requires knowing the property’s yearly expenses, it can be difficult to get an accurate estimate without the proper records. For mismanaged properties or even properties that have been owned by a single family for a long time, tracking down this information may not be possible.
Only accurate with steady income and expense costs – Like any estimate, cap rate can be thrown off by any outlying data points in terms of extra income or unexpected costs. Things like flooding damage can skew maintenance cost data for that year or unexpected seasonal business can drastically increase income, causing an inaccurate cap rate that may not actually be the typical amount year to year.
What is a Good Cap Rate?
A standard cap rate is typically between 4% and 8%, according to CBRE’s 2019 North American Cap Rate Survey. However, there is really no such thing as a “good” cap rate. It all depends on the level of risk the property owner is comfortable with and how the cap rate compares to similar properties in the area. A low cap rate is less risky, while a high cap rate is riskier but there is an opportunity to make more income. As we mentioned earlier, an unusually high or low cap rate (compared to other properties in the area) can indicate that something is “off” with the property.
Cap Rate Calculator FAQ’sBelow are a few additional clarifying answers to some of the frequently asked questions about cap rate calculators.
What Does a 7.5% Cap Rate Mean?A 7.5% cap rate doesn’t mean much by itself. Rather, it indicates the ratio between a property’s net operating income and its market value, in this case, 7.5%. Cap rate is a way of displaying how much the property is expected to make in a year using the relationship between revenue, operating costs, and market value for the property.
What this actually means in terms of good or bad investment or dollar amounts depends on the situation. For example, let’s say you want to buy a home that costs $1 million, with an expected net operating income (AKA yearly revenue) of $75,000. Using the cap rate equation of NOI (75,000)/property value (1,000,000,) you would get a cap rate of 7.5%. You can then easily compare to other cap rates in the area to evaluate your investment.
What is an Acceptable Cap Rate?An acceptable cap rate varies depending on the situation. An average cap rate is typically between 4% and 8%, but what is acceptable varies on how much risk the investor is comfortable with.
Is Higher Cap Rate Better?A higher cap rate is not necessarily better. Again, it depends on the level of risk the property owner is willing to deal with. A wealthy investor looking to make some quick income by flipping a property may be happy with a higher cap rate because of its greater earning potential, while the associated risk isn’t a concern. On the other hand, a young couple who wants to settle in a home and raise kids there for the foreseeable future will likely want a low cap rate, which has a correspondingly lower risk and will likely increase slowly over time.
Why is a Higher Cap Rate Riskier?A higher cap rate is riskier for the same reason that any high percentage investment is riskier. It all has to do with probability and potential uncertainty, something called the Risk-Return Tradeoff, a well-known investment principle. The math behind the Risk-Return Tradeoff is a bit complicated, but this guide from Model Investing breaks things down into easily understandable sections if you want to get into the nitty-gritty.
Is Cap Rate the Same as ROI?No, the cap rate is not the same as ROI. Though both metrics use NOI in their calculations, they’re measuring different things. Cap rate is used to evaluate how profitable a piece of property should be in comparison to the market, regardless of buyer, while ROI (return on investment) is a more concrete calculation showing how much a specific owner will make each year. ROI incorporates mortgage payments while the cap rate does not.
The equation for ROI is annual return/total investment. For example, a person living in a $200,000 home with an NOI of $12,000, an annual mortgage payment of $5,000, and a down payment of $40,000 would calculate ROI as follows: $7,000 annual return ($12,000 NOI – $5,000 mortgage)/$40,000 total investment (down payment) = 0.175 or 17.5% ROI. The cap rate for the same home would be 6% ($12,000 NOI/$200,000 property value).
We hope that the following explanations were helpful for any agent looking to provide a more holistic view of property options to their clients.
Now that you understand how cap rates work, here is an easy calculator that you can use.
The post Easy Cap Rate Calculation: How To Use Cap Rate In Real Estate? appeared first on Norada Real Estate Investments.