Cap rate explained – how to calculate cap rate?

Author Casaldra Andreassen Read bio
Tags: cap rate
Date: April 6, 2021

In real estate, the capitalization rate, known also as a cap rate, represents the percentage rate used to estimate the value of some investment property in the capitalization. The use of cape rate is to transform net operating income into a rental property’s market value.

The Cap Rate Formula:

Property Value = NOI / Capitalization Rate

This capitalization rate formula is a way of indicating investment value and the expected return. For example, there is a greater demand for apartment buildings that have forced capitalization rates down, meaning higher prices for these investment properties.

What is Cap Rate?

The capitalization rate, or cap rate, is usually defined as the first year, stable, operating income, divided by the present value or the current purchase price.  The cap rate is used to convert some property’s net operating income into the property’s investment value

Assuming that we know the cap rate of a rental property in a given market is 10%, we can calculate the property’s income and the cap rate returns. If you invest $100,000 in the property, it will generate $10,000 of income at the end of the year.

This capitalization approach is the same concept used to calculate what an investment in a rental property should be.

Pros and Cons of Cap Rate Investment

The cap rate calculator is a convenient and quick method to determine if the value or purchase price of investment meets the investor’s criteria or even needs and wishes for the future. 

However, the capitalization rate alone is not meant to be the sole reason for the purchase of some property. Proper due diligence and other factors actually determine if an investment is worth the risk. These factors are usually some of the following:

  • Location 
  • Demographics  
  • Growth 
  • Supply vs demand
  • Loan-to-value and 
  • Debt coverage ratios

On the other side, calculating the cap rate comes with some disadvantages. The main downside in using the cap rate calculator to analyze an investment property is that the cap rate only shows the first-year stabilized net value of the operating income for a property. 

The cap rate has an inverse relationship to value, so if the property’s operating costs change in the future years, the cap rate changes and therefore its value.

An old building with interesting details - cap rate blog

The Capitalization Rate Formula Calculator

We can determine the cap rate by dividing some property’s net operating income by the price asked or the price offered. These rates can vary for each seller and buyer. For a buyer to find the value and the maximum price of a property, he needs data on the property:

  • Gross operating income (GOI) – the annual rent fees directly received from tenants and the rent amounts for unoccupied units (local demographic trends, population density, and personal income influence rental income);
  • Operating expenses (taxes, insurance, maintenance, repairs/replacements, and all other management costs) – information that helps anticipate expenses
  • The capitalization rate – the buyer is advised to evaluate the property’s type and condition.

GOI – operating expenses = NOI (net operating income). The NOI establishes a return of capital invested (mortgage and equity financing) to purchase and renovate the property (this is also referred to as the recovery of invested capital allocated to improvements) and return gains on capital invested (the taxable part).

The cap rate provided by the seller’s agent arranges the rate of return (cap rate) – usually acceptable to maintain some property in the future. Only when the buyer sets a satisfactory cap rate, can the maximum value acquired be calculated (and only if they have a documented NOI).

The Cap Rate At Reversion & The Entry Cap Rate

The capitalization rate is used to assess rental properties. This means that during the life of an investment, the cap rate establishes the value of a purchased or sold property.

When examining the return of an investment over time, all the cash flow of the property is taken into consideration to calculate the total return. The capital considered is the outflow when the investor has purchased the property, and the cash he has received upon the property is sold.

The going-in cap rate is the capitalization rate used to define the value of the property when the investor acquires some real estate. Since the investor is entering the investment, can also be referred to as the entry cap rate.

The going-out cap rate is the capitalization rate used to specify the value of the investment upon its conclusion. Considering the investor is exiting the investment, this cap rate is known as the exit cap rate.

The reversible cap rate is compatible with the exit cap rate, or the cap rate going out. It is a reversed cap rate because it is used at the sale of the investment when the gains return back to the investor.

Cap Rate Examples – can you recognize a better deal?

Let’s take a look. Even though some property has a higher net operating income (NOI), its interest rates are proportionally higher too. Many factors can affect the interest rate which ultimately leads to a lower investment equity income.

Factors such as loan amount, property type and age, tenants, location, credit history and wholesome economic condition, etc have a great impact in determining the appreciation rate and ultimately the value of some commercial property.

Therefore, Innovation Property Group recommends that before rushing to purchase a property and analyzing the investment based on the cap rate yourself, give us a call and we will perform the proper due diligence so that proper decisions are made based on actual data.