The capitalization rate, or cap rate, is the expected rate of return on an investment property.

When it comes to evaluating investment options, cap rates can help you compare the level of risk and return on multiple similar properties. However, cap rate isn’t the only factor to consider.

Whether you are looking to purchase a residential rental property or a commercial space, cap rate will help you determine how quickly you will make back the money you’ve invested.

Calculating cap rates

The cap rate of an investment property is expressed as a percentage. This number indicates how much of your investment you are expected to make back in one year.

To calculate the cap rate, you first need to find your net operating income (NOI). Your operating income is any money you make from rentals, fees, and other amenities. From this total, you will need to subtract any expenses, including property taxes, insurance premiums, repairs, and legal costs. There are also less obvious expenses to consider, including potential vacancies.

Once you subtract your annual expenses from your gross income, you have your NOI.

Take your NOI and divide it by the current market value of the property. (You could also divide by the purchase price, but current market values make for better comparables between investment options as purchase prices are not always as relevant).

The calculation would look like this:

Net operating income / Current market value = Cap Rate

Multiply your cap rate by 100 to get a percentage.

Once you have this number, you can also use it to calculate how long it would take you to recover your investment. For example, if you have a cap rate of 5%, it would take 20 years to earn back 100% of what you paid.

What is the ideal cap rate?

There is no single cap rate that works for every property or investor. There are always multiple factors to consider, the most important one being your comfort level.

A higher cap rate generally means higher income and return, but also lower property value and greater risk. On the other hand, a lower cap rate means less income and more time needed to make back the investment, but it can also indicate better property value and less risk.

Most experts suggest aiming for 4-10%, and we would agree.

Ultimately, what matters most is how comfortable you are with the risk level involved in your investment. Small market fluctuations, vacancies, or property upgrades can all have a significant impact on the cap rate. Any surplus income you bring in with a higher cap rate is attributed to a greater risk factor.

While cap rate is a great way to compare your real estate investment options, it is not the only metric you want to look at before purchasing a property. Cap rates are only useful information as long as the value of the property remains stable long-term. Thus, you should also look at the return on investment, internal rate of return, and factors such as local markets and individual characteristics of the property.

A Realtor® can help you do detailed research on the conditions, location, and value of the property you want to invest in to help you make the most informed decision.

Are you interested in investing in real estate? Contact us to get started on your search.