In the real estate sector, it’s essential to know a property’s cash value and how much you will reasonably expect as returns on investment. The capitalization rate, also known as cap rate, is one way of determining a property’s worth and how much income it can generate.
Cap rate is the ratio of the Net Operating Income (NOI) to the property asset value. Though an easy way of calculating property value, it is often misunderstood and misapplied. You can quickly determine the value of a rental property using a free cap rate calculator. Using a cap rate calculator helps you evaluate a potential rental property relative to available alternatives quickly.
Factors that Can Affect Capitalization Rate
Before learning how to calculate a property’s capitalization rate and use a cap rate calculator, you may want to check out factors that can affect the cap rate.
Type of Property
The type of property and its use or intended use affects the cap rate value. Whether a property is residential, commercial, mixed-use, or special use influences how much it can command on the real estate market. The property type determines running costs, risks, and potential income, all factors in cap rate determination. When it comes to rental property capitalization, understanding the intricacies of calculating cap rate is vital for investors. A cap rate calculator is a valuable tool that simplifies the process, helping you make informed decisions and evaluate the potential return on your real estate investments effectively.
Property Value
The value of a property also significantly impacts its cap rate. In an upscale metropolis, a piece of real estate will have a higher cap rate than a similar property in a rural area. This difference is because large municipalities can draw more tenants and typically carry less risk – realtors and brokers group properties in the exact location into classes based on condition and quality. The cap rates on high-quality properties are lower because of their higher value.
Rental Prospects
A property’s desirability also impacts its cap rate. How much prospective tenants want a property is significant when you want to calculate cap rate on rental property. Thus, the location of a property, its amenities, and the strength of a rental agreement all impact the property cap rate.
Cap Rate Formula
There are variations of the cap rate formula. The most basic way of determining the cap rate is by using the formula:
Capitalization Rate = Net Operating Income/Current Market Value
Where:
Net Operating Income is how much you expect to earn on the property throughout a year minus running costs on the property, and current market value is how much you can sell the property for at any point in time.
Another way of determining a property’s cap rate is:
Capitalization Rate = Net Operating Income (NOI)/Purchase Price
Where:
Net Operating Income (NOI) is how much you expect to earn on the property throughout a year minus running costs, and the purchase price is the cost of acquiring the property.
The second formula has some limitations that make it unpopular. It provides inaccurate cap rate values for old properties acquired at low amounts. It also does not account for the inherited property as there is no purchase price. Also, the second formula does not consider fluctuating property prices as it employs a fixed purchase price.
The capitalization rate is expressed as a percentage of the initial property cost and reveals the net loss or gain on the property within a year.
Here’s an example of how to calculate cap rate on property:
Imagine you have to choose from two available multi-family homes. The first property is located in a busy part of the city while the second is in the countryside. From your estimations, the first property will generate $100,000 annually in rent, while property taxes and expenses will cost you $20,000, leaving you with a net income of $80,000. If the property’s current market value is $2 million, then your cap rate will be:
Capitalization rate = (Net Operating Income (NOI)/Current Market Value) X 100
(80,000/2,000,000) X 100 = 4%
For the second property, you expect to receive $50,000 every year in rent while spending $10,000 on running expenses, leaving you with NOI of $40,000. If the property’s current value is $400,000, your cap rate using the same formula becomes:
(40,000/400,000) X 100 = 10%
You can quickly determine the cap rate using an online cap rate calculator. You only have to fill in the details in the spaces provided while the investment property cap rate calculator generates the cap rate.
The differences in cap rate values reveal varying degrees of risk on investment; they also reflect the amount of time it will take to recoup your investment on a property. A higher cap rate indicates a higher risk, while a lower rate means taking less risk by investing.
From our examples, the property in the city has more investment prospects based on the cap rate. In hypothetical scenarios such as these, it is easy to make an investment choice based on cap rate. But real-life situations may not be so uncomplicated. It is up to the investor to assess other factors that may influence their investment potential including,
- Tenant’s creditworthiness and consistent rental receipts
- Terms of the existing tenant leases
- Economic conditions and how they affect tenant’s businesses
- Property’s age, location, and status
Cap Rate Alternatives
There are other alternative calculations to evaluate a property’s value besides the cap rate. They include:
The Gordon Model
The Gordon model is employed when you expect your Net Operating Income (NOI) to rise at a fixed rate each year. You must consider the assumptions of this model if you want to use it to avoid getting unusable values.
Formula for the Gordon Model:
Value = Cash Flow/(Discount Rate – Constant Growth Rate)
Band of Investment Method
This method is a weighted average derived from the required return on equity and return and debt. The simplicity of this method makes it subject to a lot of skepticism. It does not account for the differences between principal and interest and ignores the fact that mortgages last for a fixed period.
Conclusion
It is essential to get a complete picture of your investment prospects before you commence rental or any form of real estate investment. A cap rate calculator provides an easy way of seeing what’s in store as you invest.