If you’re involved with any kind of real estate investment or holdings, you’ve no doubt heard the term “capitalization rate,” or its shorter version of “cap rate.” Cap rates are used by real estate investors, owners, and others involved in the industry because it helps them understand the relationship between a property’s value, and the net operating income it generates. Let’s unpack these terms, and then learn about the cap rate formula.
Property Value
A property’s value tells you how much that asset could sell for in a particular market, at a particular point in time. The general tool used for determining a property’s value is sales comparisons. With this, you compare the property to others nearby that have similar features and amenities. Many counties and municipalities do assess property values, but many times, this can be lower than what the market might pay for it.
Gross rent multiplier – or GRM – measures property value based on gross rental income. To calculate this, you’d take what you paid for the property and divide it by the annual gross rental income. A higher GRM generally indicates an overpriced property.
But again, GRM isn’t a precise figure. One possible way to determine your property’s value is to study the sales comps, then calculate your GRM.
Net Operating Income
The net operating income of a property – or NOI – is a calculation that analyzes income-generating real-estate investments. To that end, the NOI is determined by subtracting all reasonably necessary operating expenses from all revenue generated from the property.
The Cap Rate Formula
The reason for the many explanations above is because determining your cap rate requires both the property value and the NOI. The specific formula for this is:
Net Operating Income/Current Market Value
A cap rate is expressed as a percentage. Lower cap rate percentages generally signal that a real estate investment is less risky, meaning an investor might be more likely to pay more than the property is valued. A higher cap rate, meanwhile, suggests greater investment risk, meaning that investors will pay less for that particular property.
A Cap Rate Calculation Example
Let’s say that you’re thinking about buying a rental property that is being offered for $1 million. You find out from the seller that the property is generating $150,000 a year in net operating income. Based on these numbers, your calculation would be as follows:
$150,000/$1 million = 15%
So, your cap rate would be 15%.
But is this cap rate too high or too low? Another issue about calculating cap rates is that they’re highly dependent on asset types and the market in which the properties are located. As such, while a cap rate will tell you the risk of the investment you’re contemplating, that number should be considered in light of similar assets in the neighborhood.
Understanding the potential return on a real estate investment is not an exact science. But you can get a good understanding of the possible return through metrics like the cap rate. However, as market conditions and property valuations change, it’s a good idea to work with a seasoned broker and tax expert if you’re considering purchasing real estate as an investment.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Hypothetical examples shown are for illustrative purposes only.
