One of the first real estate metrics that you will see when looking for an investment property to buy is the cap rate. As a real estate investor, it is important to learn how to calculate cap rate as it will come in handy when evaluating a real estate investment opportunity or when comparing several investment properties.
In this blog, we are going to show you how to calculate cap rate for a rental property step by step. In addition to that, we introduce the ultimate real estate tool that calculates cap rate together with other real estate metrics, the rental property and Airbnb calculator.
Cap Rate: Definition
Before showing you how to calculate cap rate, let us first define what it means in real estate investing. Short for capitalization rate, the cap rate is a real estate metric that indicates the rate of return that is expected from an income generating property. In other words, the cap rate is a representation of the yield of an investment property over a period of one year.
When calculating the cap rate of a rental property, you assume that the property was purchased in cash. Therefore, a rental cap rate does not include the financing method and represents the performance of the investment property without considering mortgage payments or other forms of real estate financing.
Learning how to calculate cap rate can benefit real estate investors in two ways. First, you can use the average cap rate of sold comparable properties to determine the value of another real estate property. This method is called the income approach in real estate valuation. Second, knowing the cap rate of a given rental property gives you an idea of how much money you are going to make off that property. Let us now see how to calculate cap rate and how to interpret the results.
How to Calculate Cap Rate Step by Step
Learning how to calculate cap rate is an important step towards a complete investment property analysis. Cap rate is calculated using the following cap rate formula:
Cap Rate = NOI/ Market Value
NOI, short for net operating income, is the net income of a rental property after deducting property operation costs from the gross rental income. These costs include taxes, property management, and property insurance. As we mentioned earlier, mortgage payments are not deducted from the gross income. Cash on cash on return, on the other hand, measures the return on investment based on the initial cash invested in the rental property and takes into account the cost of financing the investment property.
Without further ado, here is how to calculate cap rate:
Step #1: Calculate the Gross Yearly Income
The gross income of a rental property is the yearly rent collected from tenants without deducting any costs. For a rental property that is rented out for $1,200 per month, gross income is then $1,200 x 12 = $14,400.
Step #2: Estimate the Operating Costs
Owning a rental property comes with a few different costs. In addition to taxes, insurance, and maintenance costs, you should also estimate vacancy costs. This is the time when your rental property is vacant. Deducting all operating costs from the yearly gross income will give you what is known as NOI (net operating income).
For example, if costs were about $100/month or $1,200 per year, then your NOI is $14,400-$1,200 = $13,200.
Step #3: Use the Cap Rate Formula to Find the Cap Rate
The final step of calculating cap rate is simply dividing NOI by the market value of the property. For example, if you know that the market value of your rental property is $150,000, then its cap rate is $13,200/$150,000 x 100 = 8.8%.
It is not always the case that the market value of the property is known. Conducting a real estate market analysis will allow you to accurately estimate the market value by examining the selling prices of recently sold real estate comps.
To learn more about how we will help you find real estate comps and conduct real estate market analysis, click here.
What Is a Good Cap Rate for a Rental Property?
Now that you know how to calculate cap rate, you might be wondering what is a good cap rate for a rental property? It is true that a high cap rate means a higher rate of return on investment, but theoretically, it also means that the investment is risky. Cap rate varies from one property type to another. For example, multifamily rentals have lower cap rates when compared to single-family properties because they are considered less risky. In a multifamily rental, if one of the units is vacant, you can still earn money by renting out other units, which is not the case if you own a single-family rental.
Cap rates differ from one property market to another. An investment opportunity in city X can be better than one in city Y, even if the one in city Y has a higher cap rate. When making a real estate investing decision, do not base your final decision solely on the cap rate. You need to use other real estate metrics as well.
The Rental Property Calculator
The rental property calculator from Mashvisor is the ultimate tool to use when evaluating a real estate investment. The tool can act as a cap rate calculator. First, it provides you with reliable cap rates for all investment properties on the platform based on data from various sources. Once you settle on a property and do some more research on the costs, you can enter them in and the rental property calculator will do the rest. Using countless data inputs and predictive analysis techniques, real estate comps, market value, occupancy rate, and other real estate metrics are provided.
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Learning how to calculate cap rate is an important step towards success in real estate investing. Not only will it help you find the best places to invest in real estate but it will point you in the direction of some of the most profitable rental properties as well.