What Is The Cap Rate Formula
The cap rate (capitalization rate) formula is actually pretty straightforward. You take the net operating income of the property (after subtracting expenses), and divide that number by the current market value.
Cap Rate = Net Operating Income/Property’s Current Market Value
What Is Net Operating Income?
The Net operating income of the property is the income generated by the property, after subtracting all the expenses. Take note – You have to work out the net operating income for the entire year rather than just one month. The explanation and example below should help clarify what we mean.
Net Operating Income = Annual Rental Income – Annual Property Expenses
Net Operating Income Example
In the example below, we are going to demonstrate how to calculate net operating income for a property generating $2000 per month in rental income.
|Net Operating Income||Annual Rental Income||Annual Expenses|
|Monthly Rent $2000 * 12||Taxes: $1900|
|Property Maintenance: $2000|
|Total Income: $24,000||Total Expenses: $5600|
What Is The Current Market Value of the property?
The current market value is simply the price that you would expect to pay for the property, when applying the cap rate formula. Even though property prices are relatively stable, it makes sense to use up-to-date pricing data. You can get this from websites like Zillow, the New Silver ARV Calculator, or your local real estate agent.
Step-by-Step Cap Rate Example
To illustrate how quickly you can assess the profitability of two similar rental properties using the cap rate formula, we are now going to run through a simple example.
Quick Reminder: Cap Rate = Net Operating Income/Current Market Value
Property A Details:
- Net Operating Income: $18,000
- Current Market Value: $225,000
- Cap Rate Formula: $18,000/$225,000
- Cap Rate: 8%
Property B Details:
- Net Operating Income: $20,000
- Current Market Value: $307,700
- Cap Rate Formula: $20,000/$307,700
- Cap Rate: 6.5%
In this example, you can clearly see that Property A (8%) has a significantly higher cap rate than Property B (6.5%). All else being equal, it would make sense for an investor to select property A in this case, provided their primary goal is to generate positive cash flow through rental income.
Cap Rate Comparison Table
To further illustrate the benefits of a higher cap rate (assuming everything else is equal), we have created a cap rate comparison table for a $200,000 property.
As you can see, a higher cap rate means that you are generating a higher net operating income, relative to the value of the property. You could say that with a higher cap rate, the annual rental income covers a greater percentage of the property’s value.
In this post, we have provided a simple summary of the Cap Rate Formula, together with some simple step-by-step examples to demonstrate exactly how to use the formula.
Our hope is that you now have a better understanding of what cap rate is and how to compare two properties using this relatively simple calculation.
Frequently Asked Questions (FAQ)
Is Cap Rate the same as ROI?
No. Although the cap rate formula is great for comparing the profitability of similar rental properties, it is not exactly the same as ROI. Typically, ROI will factor in additional costs, like loan repayments for example, and ROI can also be used to easily compare different investment vehicles, like property flips, stocks and bonds.
Ultimately, Cap Rate is a simple formula which only requires you to factor in the rental income, property expenses and property value in order to work out how profitable the investment property is likely to be.
Is a higher cap rate better?
If you are looking at two similar properties, it’s fair to say that the property with the higher cap rate will be more lucrative for a rental property investor.
To further illustrate this point, imagine you are looking at two properties that are both valued at $200,000. They have the same number of rooms and a similar plot size. The one property is generating $10,000 in rental income per year. The other property is generating $20,000 in rental income per year? Which one would you choose? Naturally, most people would choose the property that generates a higher rental income, if the property value and expenses are relatively similar.
In other words, if all the other variables are very similar and you are able to conduct an apples to apples comparison, the property with the higher cap rate will be favoured by most rental property investors.
What does 6.0% cap rate mean?
A 6.0 cap rate means that the investment property will generate a net operating income which equates to 6.0% of the property’s value. For example,
- A $100,000 property with a 6% cap rate would generate a net operating income of $6,000
- A $250,000 property with a 6% cap rate would generate a net operating income of $15,000
What does 7.5% cap rate mean?
A 7.5% cap rate means the investment property will generate a net operating income which equates to 7.5% of the property’s value. For example:
- A $300,000 property with a 7.5% cap rate would generate a net operating income of $22,500
- A $500,000 property with a 7.5% cap rate would generate a net operating income of $37,500