Enter the net operating income and the market price or value of a property into this calculator to determine the cap rate (%).
Cap Rate Formula
The following formula is used in real estate to calculate the cap rate, also known as the capitalization rate.
C = NOI / Property Value *100
- Where C is the cap rate (%)
- NOI is net operating income ($)
- Value is the market value of the property
Net operating income can further be calculated from the following:
NOI= (100-OE(%))*(100-vacancy rate)*AGI
- Where NOI is the net operating income (NOI)
- OE is the operating expenses (%) (% of total expenses)
- Vacancy Rate (%) (percentage of time spent unoccupied.)
- AGI is the annual gross income
Cap Rate Definition
A cap rate is a term short for capitalization rate. It’s a term used in real estate to describe the ratio of operating income to property value. It’s one of the many metrics used to evaluate properties and their potential to earn revenue. The higher the cap rate the better the property it is to buy, in general. There are thousands of metrics used in determining when to purchase a property and cap rate is just one of those.
When is cap rate used?
Cap rate is most often used in a situation where someone wants to sell or buy a property. When selling a property, if you are unsure what the value of your home is, you can use the average cap rate of the area to determine the value.
For example, if you have a net operating income annually of $20,000.00 and the average cap rate for your neighborhood is 10%, then you can calculate the estimated property value by dividing the NOI by the cap rate, so $20,000.00 / .10 = $200,000.00. This value would be a good place to start when putting the house up for sale.
How does a change in net income affect property value?
A change in net income will typically directly affect the value of a property. Properties a typically valued at some multiple of the net operating income. This multiple is the inverse of the cap rate. When a net income decreases, the value of the property will also generally decrease. Similarly, if the net income increases the property value will also increase.
Is cap rate the same as ROI?
A Cap Rate is often considered the same or similar to a ROI on a yearly basis. A cap rate is a percentage ratio of the net operating income to the price of a home. When purchasing a home, that cap rate is your expected return on the investment.
This get’s a little more complicated when you consider mortgage loans etc. For example, a ROI is simply a percentage return on a basis of the amount earned each period to the amount invested. When purchasing a mortgage, there is a down payment on the long-term loan. To calculate the ROI in this case, you would typically use the entire cost of the mortgage but when determining the cap rate you would only use the value of the home.
Do cap rates rise with interest rates?
Cap rates typically increase in the short term with a rise in interest rates. The reason this happens is that when interest rates rise, the price of a home typically decreases. Homes decrease in price when interest rates rise because home buyers need to spend more on mortgage interest which means less towards the principal of the house.
From there, if we look at the equation for cap rate: CR = NOI/V, when the value decreases, the ratio of NOI to the value will increase. In the long term, the operating income will typically decrease over time to match the property value change, but since renting contracts are typically one year long, they will not change in the short term.
Should Cap Rate Be High or Low?
When purchasing a home you want the cap rate to be as high as possible, when selling a home you want the cap rate to be as low as possible.
How to calculate cap rate?
The following is a step by step guide on how to calculate a capitalization rate.
- The first step in calculating a cap rate is to determine the NOI of the property. This is dependent on many factors including rent and other sources of income. For this example, we are going to assume that the NOI is $100,000.00 per year.
- The next step is to determine the market value of the property. This is typically done by an appraiser, especially for commercial properties. We will assume for this example that the property is valued at $1,000,000.00.
- The final step is to plug in the values into the formula. So, C = 100,000/1,000,000*100 = 10 %
In this example, if you were to buy the property out right, you would make back your investment in 10 years with no increase in property value.
Cap Rate is is a term used in real estate to describe the ratio of operating income to property value.