Real estate investors are driven by the same motivation – to make money from investment properties. How much money you make in real estate investing depends on your return on investment. How do real estate investors measure their return on investment? There are a number of metrics in the real estate investing business to do so; one of the most popular ones is the capitalization rate or cap rate for short.
What is Cap Rate in Real Estate Investing?
Cap rate is one of the most widely used real estate metrics to measure the return on investment or the profitability of an income property. What makes cap rate a popular metric among real estate investors is that it measures the rate of return regardless of the investment property financing method – all cash or a mortgage loan.
Cap rate corresponds to the level of risk associated with the real estate investment property: low cap rates correspond to a lower level of associated risks while high cap rates correspond to a higher level of associated risks. In real estate investing, the higher the cap rates, the better it is for the property investor because lower risks yield low profitability, while higher risks yield high profitability!
How is Cap Rate Different from Cash on Cash Return?
The capitalization rate measures the return on investment of a real estate property without taking into account the financing method used to buy the investment property. This is what differentiates capitalization rate from cash on cash return. The cash on cash return is a metric used to analyze and measure the profitability of an income property taking into consideration the financing method – all cash or mortgage loan. In other words, cash on cash return estimates the return on investment based on the rental income that the investment property will generate in relation to the amount of actual cash that the real estate investor invested.
Related: Cap Rate vs. Cash on Cash Return
How to Calculate Cap Rate in Real Estate Investing
There is a pretty simple formula which any property investor can use to calculate the capitalization rate of an income property, which is:
Cap Rate = NOI/Property Price
For example, say a property investor purchased a $200,000 investment property and paid another $10,000 to finalize the purchase. Assume the property investor is renting out his income property and charges $1,700 as monthly rent. Further, assume that annual operating costs add up to $5,000. The capitalization rate for this income property is:
NOI = Monthly Rental Income x 12 – Annual Operating Costs = $15,400
Property Price = Property Value + Other Costs = $210,000
Cap Rate = NOI/Property Price = $15,400/$210,000 = 7.3%
Related: What’s a Good Cap Rate for Real Estate Investments?
Cap Rate in Real Estate Investing – The Bottom Line
You can easily calculate cap rates of different investment properties using the cap rate calculator! Mashvisor offers a cap rate calculator and gives you access to the cap rates for different investment properties listed for sale in any real estate market!
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