If you’ve been conversant with real estate, you must have come across a rental capitalization rate or rental cap rate. But you might not know what it means, as it is usually confused with cash on cash return (COC) & rate of return. Below is all you’ve got to know about cap rate, from its definition to methods of calculation.
What Is the Capitalization Rate?
The capitalization rate allows you to compare your real estate investment’s relative value without considering their dollar value. A capitalization rate is comparable to the rate of return. The fundamental formula of cap rate is the net operating income divided by market value.
A capitalization rate is one of the most crucial calculations done by real estate investors. Cap rate is an ideal way of calculating similar properties in the same market.
A rental cap rate calculator is an online tool that allows an investor to calculate how much money a property is expected to produce and how comparable it is to other similar properties in the market area.
How to Calculate a Cap Rate
We’ve mentioned the basics of the cap rate above; below is an example of how to calculate the capitalization rate using real numbers. Below are our values:
- Value of property – $250,000
- Net revenue – $48,000/year
- Salary of a property manager – $20,000
- Broker fees and inspection – $5,000
- Cleaning and maintenance – $10,000
Let’s start by calculating the NOI, (Revenue fee) $48,000 – (Net expenses) $35,000 = $13,000.
Next, let’s calculate the cap rate of the property, which is NOI / property value = $13,000 ÷ $250,000 = 0.52 equivalent to 5.2% cap rate.
What Is a Rental Cap Rate Calculator in Real Estate Investment?
A cap rate calculator in real estate is used to find the relative value of a property to determine if it will be a good investment or not. It is calculated by balancing the property’s market value, the earning received from the property, and the costs of acquiring and maintaining a property.
For example, an aspiring investor is willing to buy your property for $250,000. The property has four units and receives $1000 from each tenant monthly. You spend $35,000 on the property manager’s salary, maintenance and cleaning fees, and inspection fees per year. A cap rate calculator will take each of these factors and come up with a percentage for easy property comparisons.
Equation of a Rental Cap Rate Calculator
The equation of a rental cap rate calculator is simple and straightforward as far as you’ve all the necessary information at hand. To calculate the rental cap rate, divide the net operating income (NOI) by the property value. If you find it hard to get the property value, many online tools provide property value estimates.
Calculating the net operating income (NOI) is a bit tricky, but if you keep track of all your expenses, figuring NOI will be easier. The formula for calculating the net operating income (NOI) is Total revenue subtracted from total costs. The total revenue is the total amount of rent collected from tenants yearly and the years’ interest. Total expenses are the sum of all the expenses in the year; this includes fees spent on pest control, fixing furnace or air conditioner, property manager salary, and other miscellaneous fees.
To find your net operating income (NOI), sum up all your sources of revenue and interest for the year and subtract it from the total expenses. You can then divide this number by the property value to get the capitalization rate. It’s crucial to note that the capitalization rate doesn’t account for mortgage payments as it doesn’t affect a property by itself.
Importance of Using a Cap Rate Rental Calculator
Cap rate is used in many ways when evaluating rental properties. Generally, the cap rate is the estimate used to get the land laid for real estate; it can also be used as a commercial cap rate calculator. Other uses of cap rate rental calculator include:
- It gives you a clearer picture of market trends in an area: A rental cap rate calculator helps indicate broader changes in a city or an area’s real estate market. For example, a cap rate improving in a neighborhood but staying constant in another area can indicate a tenant interest shift.
- It helps you identify under-the-radar opportunities: A rental cap rate calculator enables you to identify a property with a noticeable high cap rate in an area, which indicates mismanagement and the possibility for a more increased return investment.
- It helps you understand the value of a property compared to its neighboring properties: Similar properties with similar assets in a neighborhood are expected to have an equivalent cap rate. By calculating the cap rate, you’ll know if a property’s price is too high or too low. It will also help you in finding the underlying cause of the unusual cap rate.
- Cap rate provides clients with useful estimates: The most important use of a cap rate rental calculator for real estate agents is its ability to provide accurate estimates to clients for the value of a rental property, which is crucial when deciding whether to buy a property or not.
What Is Cash on Cash (CoC) Return?
The cash-on-cash return of a rental property is the property’s cash flow divided by the initial capital investment. Cash on cash return is usually expressed in percentage. Its calculation is mostly accurate in the first year’s expected cash flow. Cash on cash return isn’t regarded as a powerful measurement, but it helps you make a quick check on your property and
compare it against other investments.
A cap rate rental property calculator enables an investor to keep track of the increase and decrease of their cap rate.
Many investors think that the capitalization rate is an indicator of risk. It doesn’t seem right; the fact is that the formula of cap rate works for an income-producing property, not a property you’ll buy and sell later.