Capitalization (Cap) Rate Calculator
Key Takeaways
- Capitalization rate, or cap rate, estimates a rental property's annual rate of return by comparing net operating income to current market value.
- Cap rate is useful when investors want to compare multiple long-term, income-generating rental properties.
- The cap rate calculation does not account for financing costs, debt service, major renovations, or short-term resale strategies.
- By using a cap rate calculator, you can compare potential rental properties more clearly and make more informed decisions about profitability and risk.
Capitalization Rate (Cap Rate)
When evaluating an investment property, using rental metrics and analytics is crucial for making informed decisions. Metrics provide a clear picture of a property's current or potential financial performance, helping investors gauge profitability and mitigate risks.
Capitalization rate is one metric that can help investors optimize their portfolios, ensuring they make the most out of their real estate investment property. Using an online cap rate calculator is an easy way to make this calculation simple and quick.
What is Capitalization Rate?
Capitalization rate, or cap rate, is a 12-month assessment that measures how quickly an investor can make back what they spent on an investment property. In other words, it's the annual rate of return that property is expected to generate.
Cap rate is a useful metric for quickly comparing multiple potential real estate investments. It is similar to other return on investment metrics, however, in that it isn't a perfect predictor of a property's success. Cap rate should always be considered in context and in coordination with other metrics to get the fullest picture of a potential investment's profitability.
Cap Rate Formula
The formula to calculate cap rate for a real estate investment is as follows:
Cap rate = Net operating income (NOI) / Current market value
As you can see, there are two components of the cap rate formula: The property's net operating income (NOI) and its current market value.
NOI is the income a property generates after regular, monthly expenses are subtracted, excluding variable expenses like maintenance, income taxes, and interest. Given this, NOI is calculated as follows:
Net operating income (NOI) = Gross operating income (GOI) - Operating expenses
Note that vacancy loss is accounted for in NOI, meaning your gross operating income in the formula above should exclude any income you would lose due to vacancies throughout the year.
The bottom half of the cap rate formula is simply the property's current market value. This is the present-day value of the property. You can get this number via a formal appraisal or by doing a comparative market analysis.
Cap Rate Formula Overview
| Cap Rate Component | What It Means | Formula or Example |
|---|---|---|
| Cap Rate | The annual rate of return a property is expected to generate. | Cap rate = NOI / Current market value |
| Net Operating Income (NOI) | The income a property generates after regular operating expenses are subtracted. | NOI = GOI - Operating expenses |
| Gross Operating Income (GOI) | Rental income after accounting for vacancy loss. | Annual potential rental income - Annual vacancy loss |
| Current Market Value | The present-day value of the property. | Formal appraisal or comparative market analysis |
| Assessment Period | The timeframe represented in the calculation | e.g.,12 months |
When to Use Cap Rate
Cap rate is best used when analyzing potential long-term, income-generating investment properties. When real estate investors are looking at multiple properties with different features, prices, and risks, cap rate provides a baseline metric that can be compared across properties to assess future profitability.
Cap rate is not the best metric to use for short-term investments like fix-and-flips. This is because the cap rate calculation does not include the upfront cost of repairs and renovations, nor the fact that you'll be selling the property instead of holding it to generate income. Cap rate may also be an inappropriate metric when financing plays a large role, since the calculation does not account for financing costs. In this situation, a metric like cash-on-cash return may be more useful.
How to Use the Cap Rate Calculator
Using REI Grove's real estate cap rate calculator is a quick and easy way to project an estimate of a property's future income. Let's look at the inputs you'll need as well as the result.
Inputs
Here are the inputs you'll need to use in the calculator:
- Current market value
- Annual potential rental income
- Annual vacancy loss
- Annual operating expenses
Current market value is the present-day property value, found via an appraisal or comparative market analysis. Note that this isn't necessarily the same as the property's purchase price.
Annual potential rental income is the sum of all types of income you expect to generate from the rental property over a 12-month period. You should include all the following:
- Rents
- Nonrefundable deposits
- Pet rent
- Parking fees
- Tenant utility payments
- Any other payments received for the use or occupation of a property
Annual vacancy loss is the amount of rental income you'd expect to lose when your property is vacant throughout the year. This can be found by estimating how many weeks or months of the year you'd expect to find your property vacant, then multiplying to determine how much income you'd lose at the rate you intend to rent the unit for.
Lastly, annual operating expenses are the sum of all non-variable, regular expenses you expect to incur from a property to cover its day-to-day operations. In your annual operating expenses, be sure to include:
- Property management fees (including software fees)
- Advertising and listing fees
- Landlord insurance premiums
- Property taxes
- Cleaning and maintenance fees
- Supplies
- Travel costs if you travel to your office/properties
- Legal fees
- HOA fees
- Utilities you cover
Outputs
After you've entered the above inputs, the cap rate formula calculator will generate a few outputs, including your cap rate:
- Gross operating income (GOI)
- Net operating income (NOI)
- Cap rate
Gross operating income is simply your total rental income accounting for vacancy loss. Subtract your operating expenses from that, and you get your net operating income (NOI).
NOI is used in the final calculation for cap rate, which is expressed as a percentage.
How to Interpret Your Cap Rate
What is a good cap rate?
According to Investopedia, most analysts consider a "good" cap rate to be between 5% and 10%, as these usually indicate the best balance of returns and risk tolerance. Because cap rate is a ratio between a property's valuation and its return, the best cap rate is a balanced one.
- A high cap rate typically indicates a higher return on investment but often comes with higher risk (e.g., properties in less desirable locations or with volatile income streams).
- A low cap rate suggests a lower return, but these properties are usually seen as lower risk (e.g., in stable, high-demand areas with more reliable income).
- Investors seeking higher returns and willing to take on more risk may prefer a high cap rate, while those prioritizing stability may favor a low cap rate.
That being said, there is no definite standard for "good" or "bad" cap rates. The meaning of your cap rate largely depends on the context of the investment and its comparison to other markets/properties. The same cap rate may be an overall positive or a negative depending on the property it refers to. Likewise, the same property may have different cap rates at different points in your ownership of it.
Keep in mind that the cap rate calculation can hide a few important factors that could skew the results. For example, cap rate does not account for debt service, so changing interest rates or mortgage payments are not included in cap rate but nonetheless affect your property investment. Additionally, when you use cap rate to evaluate profitability before purchasing a property, you'll need to approximate the rental rate and total expected income, which means the cap rate calculation should come after you research the rents of similar properties in your local area.
Cap Rate Breakdown
| Cap Rate Result | What It Could Suggest | What to Consider |
|---|---|---|
| Higher cap rate | Higher potential return | May involve higher risk, such as less desirable locations or less stable income. |
| Lower cap rate | Lower potential return | Usually a lower-risk property in a stable or high-demand area with reliable income. |
| 5% to 10% range | Often cited as a range many analysts consider balanced | The right cap rate still depends on market, property type, investor goals, and risk tolerance. |
Conclusion
Cap rate is a valuable tool for evaluating the potential return on income-generating properties, helping investors make hard decisions about profitability and risk. While it provides a quick snapshot of a property's performance, it's important to consider other factors like financing and market trends to get a complete picture of the investment.
If you're ready to analyze your potential next property, you can use REI Grove's cap rate calculator and many more investor resources below.
FAQs
What is cap rate in real estate?
Cap rate is the annual rate of return a property is expected to generate. It compares a property's net operating income to its current market value.
How do you calculate cap rate?
The cap rate formula is NOI / Current market value.
What inputs do I need for a cap rate calculator?
To calculate your property's cap rate, you'll need its current market value, annual potential rental income, annual vacancy loss, and annual operating expenses.
What does current market value mean?
Current market value is the property's present-day value. Investors may determine it through a formal appraisal or comparative market analysis.
What income should I include in annual potential rental income?
Annual potential rental income may include rents, nonrefundable deposits, pet rent, parking fees, tenant utility payments, and any other payments received for the use or occupation of a property.
What does a cap rate calculator output?
A cap rate calculator may output gross operating income (GOI), net operating income (NOI), and cap rate.
What is a good cap rate?
Many analysts consider 5% to 10% a good cap rate range, but there is no definite standard. The right cap rate depends on the market, property, investor goals, and risk tolerance.
Is a higher cap rate always better?
No. A higher cap rate may indicate higher return potential, but it often comes with higher risk. A lower cap rate may indicate lower return potential but more stability.
Does cap rate include mortgage payments?
No. Cap rate does not account for debt service, mortgage payments, interest rates, or other financing costs.
Should investors only use cap rate to evaluate a property?
No. Outside of cap rate, investors should also consider financing, market trends, property condition, cash-on-cash return, and other relevant factors.