What is the cap rate?
By definition, cap rate is simply the rate of return on a real estate investment property. In other words, it describes what part of your initial investment will return to you every year.
For example, imagine that you bought an apartment for $100,000 and the cap rate is 10%. It means that each year, 10% of the initial investment will return to you. As you can easily calculate, after 10 years your net cash flow will be equal to zero, which means that from the eleventh year on, you will start to actually make money on this investment.
How to calculate the cap rate?
You can use the aforementioned formulas manually, or calculate the cap rate with this handy cap rate calculator. To do it, follow these simple steps:
- Begin with determining the property value – it can be, for example, its selling price. Let’s say it is equal to $200,000.
- Find out your gross rental income. It is simply the amount of money you get from your tenants each year. Let’s say it is equal to $30,000 per year.
- Determine the vacancy rate. Let’s say that the property stays unoccupied for 2% of the time.
- Decide on the percentage of operating expenses. Let’s say you have to spend $500 monthly on expenses – this is $6000 a year, what is equal to 20% of your gross income.
- Use the formula above to calculate the net rental income:
net income = (100 - 20)% * (100 - 2)% * $30,000 = 0.8 * 0.98 * $30,000 = $23,520
- Lastly, divide the net income by the property value to obtain the cap rate:
cap rate = $23,520 / $200,000 = 11.76%
Capitalization rate application: selling a property
When do we need to calculate the cap rate? Imagine the following situation: you want to sell your property. You are not sure what is the price you should call. The only thing you know is that your monthly operating income is $2,800, which is equivalent to $33,600 a year.
The best thing to do is to ask around for the cap rate. You are most likely to get this type of information from a commercial real estate agent. Let’s say the average cap rate in your neighborhood is 9.7%.
To calculate the market value of your property, you simply have to divide the net income by the cap rate:
$33,600 / 9.7% = $33,600 / 0.097 = $346,392
This is the value of your property. Of course, consider this rather as a rule of thumb – there might be other reasons for increasing or lowering the selling price. Nevertheless, this is a good point to start from.