How To Calculate The Cap Rate
One of the most important formulas for investing in real estate is the cap rate. Most investors look at the capitalization rate in order to know if the property is the right investment. With this formula, the investor can calculate the cap rate, value of the property, and the net operating income.
The Importance Of The Cap Rate From An Investor’s Perspective
Positive cash flow is important for an investor. Cap rate gives the investor information about the income compared to its value. Consider the question that every investor must ask: is the purchase price worth it, given the cash flow? Generally, investors should seek a cap rate between 4% and 12%. This will vary depending on the type of property and location. For example, when it comes to multifamily properties, often low income housing has a higher cap rate. However, just because the cap rate is higher does not make the property better. Many low income housing properties tend to have high turnover and more repairs which can lower your overall profit.
Formula for Calculating the Cap Rate
The basic formulas are below. Note that “Income” refers to Net Operating Income. “Value” refers to the Sale Price and “Rate” refers to the Capitalization Rate. Gathering the information to calculate the cap rate is easy, and all the information is available on the property listing or by asking the listing agent.
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Calculating Cap Rate of a Duplex (Example of Capitalization Rate)
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Sale Price = $889,990
Net Operating Income = $50,955
Cap Rate = Net Operating Income / Sale Price
Cap Rate = $50,955 / $889,900
Net Operating Income = $50,955
Cap Rate = 5.72%
Above is a listing I found on the realtor website. With the purchase price of $889,900 and NOI of $50,955. The realtor website does not provide the Net Operating Income (NOI). The information is available on Multiple Listing Service (MLS). However, only real estate agents have access to MLS. Ask the listing agent for operating expenses and cash flow. Given the information the cap rate is 5.72%.
Increasing the cap rate is simple. Increase the NOI and lower the sale price. Let's assume that the seller is desperate to sell the property and ends up selling for $600,000. The new cap rate will be 8.49%. This is one of the reasons why negotiating on the buy is so important. Apart from getting a discount on the property, it increases the cap rate.
Cap Rate = $50,955 / $600,000
Cap Rate = 0.0849
Cap Rate = 8.49%
Issues With Cap Rate
Cap rate does not mean much if your property is vacant. Having a vacant property will reduce your cash flow, and your cap rate can drop dramatically. Looking for properties that have a high enough occupancy rate is important, as you do not want to be struggling to find tenants. Single family homes can also be an issue when calculating the cap rate. If you are an investor who is looking for single family homes, you may not get the NOI from the real estate agent. Single family homes are generally sold to families, therefore there will be no cash flow information. You will have to study the local market to see what is the rent price for the given property, and estimate yourself.
Visit the Realtor.ca website and try calculating the cap rate by yourself. At the end of the day, cap rates are estimates that investors use to judge a property. Just because the property has a high cap rate does not mean it is automatically a good property to purchase.