Real Estate Capitalization Rate Calculator
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(Taxes, insurance, maintenance, vacancy, management fees)
Net Operating Income (NOI)
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Capitalization Rate
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How is Capitalization Rate Calculated?
The Capitalization Rate, or "Cap Rate," is one of the most fundamental metrics in commercial and residential real estate investing. It measures the expected rate of return on a real estate investment property based on the income the property is expected to generate. It is specifically used to estimate the investor's potential return on their investment in a cash purchase scenario (excluding debt/mortgage financing).
Cap Rate = (Net Operating Income / Current Market Value) × 100
Step-by-Step Calculation Formula
To calculate the Cap Rate manually, you must follow these specific steps:
- Step 1: Determine Gross Annual Income. Calculate the total income the property generates in a year, primarily from rent, but also including other sources like parking fees or laundry facilities.
- Step 2: Subtract Operating Expenses. Deduct all costs required to operate the property. This includes property taxes, insurance, property management fees, maintenance costs, utilities paid by the landlord, and a vacancy allowance. Note: Do not deduct mortgage payments (principal and interest) or capital expenditures (major renovations) when calculating Cap Rate.
- Step 3: Calculate Net Operating Income (NOI). The result of (Gross Income – Operating Expenses) is your NOI.
- Step 4: Divide by Property Value. Divide the NOI by the current market value or the purchase price of the property.
- Step 5: Convert to Percentage. Multiply the result by 100 to get the Cap Rate percentage.
Calculation Example
Imagine you are looking at a four-plex apartment building listed for $1,000,000. Here is how the numbers break down:
- Gross Income: The 4 units rent for $2,500 each per month. ($10,000/month × 12 = $120,000/year).
- Operating Expenses: Taxes, insurance, and maintenance total $35,000 per year.
- Net Operating Income (NOI): $120,000 – $35,000 = $85,000.
- Calculation: $85,000 / $1,000,000 = 0.085.
In this scenario, the Cap Rate is 8.5%. This means if you bought the property with all cash, you would earn an 8.5% annual return on your investment based on current income.
Why is Cap Rate Important?
The Cap Rate allows investors to compare properties of different sizes and prices on an apples-to-apples basis. It helps assess risk; generally, a higher Cap Rate implies higher potential returns but also higher risk (often found in older buildings or less desirable neighborhoods), while a lower Cap Rate suggests a safer, more stable asset (like a brand new building in a prime location).