How is Cap Rate Calculated?
The capitalization (cap) rate for a property is a ratio that measures the annual rate of return for an investment property. It is commonly used as a measurement to compare like properties for appraisal valuations or other comparative analysis. A cap rate is calculated by dividing the Net Operating Income (NOI) of a property by the purchase price (for new purchases) or the value (for refinances).
Cap Rate = NOI/Value
Purchase Price or Market Value (Refinance) = NOI / Cap Rate
Cap Rate Calculator
In order to calculate the capitalization rate, you need the property’s net operating income readily available. If you must calculate the property’s net income first, you would subtract all of the expenses directly related to the property (excluding mortgage interest, depreciation, and amortization) from the income of the property. For the purposes of this example, say you are purchasing a property for $1,000,000 that has gross rents of $100,000 and expenses of $30,000. This would give you a NOI of $70,000. In order to calculate the cap rate from there, you would divide the $70,000 NOI by the $1,000,000 purchase price, giving you a cap rate of 7.0%.
NOI: $100,000 – 30,000 = $70,000
Cap Rate: $70,000 / $1,000,000 = 0.07 (7.0%)
What Are Cap Rates Used For?
- Real Estate Valuation: The value of the property = NOI / Cap Rate. Appraisers often employ this method to determine valuations by using cap rates from similar properties.
- Property Comparisons: Capitalization rates should be the same for properties around the same area with similar conditions, usage, and risk profile. If there is a difference in cap rates for similar properties, it could be due to mismanagement, under-renting, or another opportunity for a value-add scenario.
- Returns Analysis: By definition, a capitalization rate is the rate of return that you can expect from a property after considering all of the income and actual expenses.
- Market Analysis: The strength of a specific real estate market is reflected in the cap rates of the area; the lower the cap rate, the stronger the market (because the properties are in higher demand). This is often seen in large cities like New York, San Francisco, or other desirable locations.
Limitations on Cap Rates
Cap rates are useful for many purposes, but there are some circumstances on which their accuracy cannot be relied upon in order to make financial decisions. The following are some circumstances where cap rates may not be useful to a real estate investor:
- Specialty Use Properties: Because specialty use properties are designed for a specific business or function (i.e. car wash, church, auto repair, etc.), it is sometimes difficult to find enough direct comparables to establish a dependable cap rate across that asset type.
- Small Markets: Because small markets have less properties and therefore less sales, there is a smaller pool of comparables to choose from when looking at the cap rates; it may lead to using properties that may not be recent or direct comparables, but rather “adjacent” to what you’re looking for, causing misleading cap rates that may not accurately reflect the current market.
- Operating History: If a property has an inconsistent or unknown operating history (i.e. income and expenses) or is an owner-user property, it would be very difficult (if not impossible) to come up with an income and expense projection that could be applied to a cap rate, which would make it hard to determine a definitive valuation.
It is important to keep in mind that the capitalization rate ratio can be very useful for helping determine whether or not a property is worth continued diligence, but it should not be the only thing that a real estate investor should rely upon when considering the purchase of a commercial property.
Note: The commercial mortgage calculators displayed in this website should be used as a guideline and do not represent a commitment to lend. Commercial Loan Direct and CLD Financial, LLC are not liable for any calculation errors resulting from the use of these calculators.