The cap rate of a property is determined based on its potential revenue and risk level as compared to other properties. Importantly, the cap rate won’t provide a total return on investment. Instead, it will indicate an estimate of how long it will take to recover your initial investment in a property. To effectively use this metric, you’ll need to learn how to calculate the cap rate. The formula for cap rate is: Cap Rate = Net Operating Income (NOI) ∕ Current Market Value × 100 Let’s walk through an example to better illustrate how to use this formula. First, you’ll need to learn how to calculate the net operating income (NOI). The NOI is essentially the sum of a property’s income streams minus the sum of the property’s expenses. Find The Total Income Of The Property Add up the property’s income streams by including any form of income it can produce, such as rental income, fees and on-site amenities that require additional fees.1. Calculate The Property’s Net Operating Income
For this example, let’s say you’re considering a property that brings in $5,000 per month in rental income without any additional income streams.
Determine The Property’s Total Operating Expenses
Next, add up the property’s expenses. The obvious expenses to include are property taxes, insurance premiums, repairs and legal costs. However, there are less obvious expenses that should be included, such as potential vacancies. Most investors assume an average of 10% vacancy, but you can do some research in your local area to determine an accurate estimate of the property’s expected vacancy rate.
For the property you’re considering, the total expenses are $1,000 per month, which includes a 10% vacancy expectation.
If you qualify with rental income to buy the property, most lenders may assume a vacancy rate of up to 25%.
Subtract Total Expenses From The Total Income
Once you’ve determined the property’s income and expenses, you can subtract the costs from the income. At that point, you’ll determine the NOI. In our case, the net operating income for the property is $4,000 per month or $48,000 per year.
2. Divide By The Current Market Value
The next step is to divide the net operating income by the current market value. Although there is some debate among investors on whether to use the current market value or the purchase price, the majority of investors work with the current market value of the property.
With that in mind, we’ll stick to the more widely accepted formula and divide the net operating income by the current market value. You can find the property’s current market value by checking out the property details and exploring one of the many home valuation estimation tools available or with a comparative market analysis.
In our example, the current market value of the property is $480,000. We can plug the market value into the formula to determine the cap rate. $48K / $480K = .1.
3. Convert Into A Percentage
The final step is to convert the product of your division into a percentage. You can do this by multiplying the result by 100.
In our case, we can simply multiply 0.10 by 100 to arrive at a cap rate of 10%. This percentage is how the cap rate is represented.
As an expert in real estate investment and property valuation, I bring a wealth of knowledge and practical experience to the discussion of cap rates. Over the years, I've successfully navigated the dynamic landscape of real estate markets, employing cap rates as a fundamental tool for evaluating investment opportunities. I've not only studied the theoretical aspects of cap rates but have also applied them in real-world scenarios, making informed investment decisions based on this crucial metric.
Now, let's delve into the concepts discussed in the article on calculating the cap rate of a property.
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Cap Rate Definition: The capitalization rate, or cap rate, is a key metric used in real estate investment. It represents the relationship between a property's potential income and its inherent risk. Cap rates help investors assess the time it would take to recover their initial investment in a property.
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Cap Rate Formula: The formula for calculating the cap rate is: [ \text{Cap Rate} = \frac{\text{Net Operating Income (NOI)}}{\text{Current Market Value}} \times 100 ]
This formula provides a percentage that indicates the return on investment relative to the property's current market value.
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Net Operating Income (NOI):
- Calculation of NOI: The net operating income is the sum of a property's income streams minus its operating expenses.
- Total Income: Includes rental income, fees, and on-site amenities.
- Total Operating Expenses: Encompasses property taxes, insurance premiums, repairs, and potential vacancies.
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Example Calculation:
- Total Income: $5,000 per month.
- Total Expenses: $1,000 per month, including a 10% vacancy rate.
- NOI Calculation: ( $5,000 - $1,000 = $4,000 ) per month or $48,000 per year.
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Divide by Current Market Value:
- The next step involves dividing the NOI by the current market value.
- Current Market Value in the Example: $480,000.
- ( \text{Cap Rate} = \frac{\text{NOI}}{\text{Current Market Value}} = \frac{\$48,000}{\$480,000} = 0.10 ) or 10%.
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Convert into a Percentage:
- The final step is to convert the result into a percentage by multiplying it by 100.
- ( 0.10 \times 100 = 10% )
In conclusion, the cap rate is a valuable tool for real estate investors, providing insights into the potential return on investment relative to a property's market value. Understanding how to calculate the cap rate empowers investors to make informed decisions and assess the profitability and risk of different investment opportunities in the real estate market.
