Simply put, the cap rate refers to the return rate on an investment such as for a real estate property. This describes the part of a person’s initial investment that he will get in return each year. You can compute this by using a cap rate formula or, to make it easier, you can also use this cap rate calculator. Read on to learn more about it.
How to use the cap rate calculator?
Nowadays, there are plenty of online tools which help make computations and calculations simpler for us. For one, this capitalization rate calculator only needs a few easy steps to use:
- First, enter your Property Value which is a monetary value.
- Then enter the Annual Gross Income value which is also a monetary value.
- Next, input the percentage value of the Vacancy Rate and the percentage value of the Operating Expenses.
- After entering all of these values, the cap rate calculator will automatically generate the Annual Net Income and the Capitalization Rate.
What is a capitalization rate?
The capitalization rate, also known as the “cap rate” is a fundamental concept that’s commonly used in commercial real estate. It refers to the return rate on an investment of a real estate property. It’s based on the income you expect the property to generate. This is a measurement that’s used to estimate the potential return of an investor. You can get this value using a cap rate formula:
Capitalization Rate = Net Operating Income / Current Market Value
How to calculate cap rate?
One look at the formula, you will see that it’s quite easy to calculate the cap rate. A simpler explanation is that it’s the ratio between the property value and the net income. You can manually compute by following these steps:
- Start by determining the value of your property. For instance, this can be the property’s selling price.
- Then, determine the gross rental income of your property. This refers to how much money you would get from your tenants annually.
- The next step is to determine your property’s vacancy rate. Then, decide the percentage of your operating expenses.
- Before you make the final calculation, you should compute for the Net Operating Income using this formula:
Net operating income = Gross operating income – operating expenses
- Once you have all the values needed for the formula, you can start making your manual calculations to end up with the final cap rate.
What is a good cap rate?
There is no definite answer to this question. A good cap rate would depend on the situation. For instance, if you want to purchase an asset that’s fully stabilized, then you should search for a property that has a trading value that’s average in the area you live in.
Conversely, if you’re looking for a property which has the potential to increase in value, choose one that’s trading at a low cap rate. But if you want an investment with a high potential for cash-flow but isn’t focused on value-add, then choose one with a high cap rate.
Investors perceive “good” and “bad” cap rates differently. There are different cap rates which occur among types and categories of commercial and residential real estate. But there are several factors which have an effect on the cap rate such as:
This class includes property types such as apartment buildings, multifamily, commercial properties or industrial properties. Usually, residential property has a lower cap rate compared to a commercial property because the latter tends to have higher rent.
This refers to the number of available properties in the area. Typically, a lower inventory would mean a higher demand which, in turn, leads to properties which have lower cap rates.
Typically, rising rates would indicate a drop in the value of properties. When the rates increase, the debts would rise which would then decrease the net cash flow. Rising rates may lead to low cap rates.
The location of the property would drive the demand. Properties in a desirable location have a higher market value which means that the owners can ask for higher rents. In such cases, the cap rate doesn’t change.
Do you want a higher or lower cap rate?
Generally, a cap rate which falls between 4-10 percent is already considered a “good” cap rate. But it would still depend on the factors we’ve discussed in the last question. Good cap rates are typically subjective, and investors may view these in different ways.
For buyers, they would prefer a high cap rate. This means that it has a low purchase price compared to the NOI. But a high cap rate also means that it involves more risk while a low cap rate also comes with a lower risk.
A property may even have a high cap rate even though it’s in a location where its appreciation isn’t on the same scale as other areas. In such a case, the investor needs to consider the risks and determine the suitable cap rate for his investment goal.
A property that has a high cap rate may not take into account the rate of occupancy. It would make use of expected rent values instead of current rent values. Otherwise, the property might be in an area where there’s a low demand for investment properties.
On the other hand, a property which has a low cap rate might be in a costly area, and people may consider this as more desirable, therefore, increasing the demand for that property type. Before investing in a property, you should check its cap rate so that you can understand the entire financial picture of the investment.
Also, when comparing properties in determining which one has a good cap rate, only compare the same types of properties in similar locations. For instance, it’s not appropriate to compare the cap rates of multifamily properties against commercial properties which have retail tenants. This is because the former would have a lower risk along with a lower reward investment compared to the latter.