Cap Rate: Explanation and Calculator
Determine your commercial property's capitalization rate with our calculator. Cap rates are critical for assessing the profitability of an investment.
What Is a Cap Rate?
A capitalization rate, more commonly known as a cap rate, is a commercial real estate finance metric that represents the net gain or loss of profit that is expected to be generated on an investment property, measured over a specified time period (typically a year). To determine the cap rate of an asset, divide the property’s net operating income (NOI) by its market value. The resulting figure, expressed as a percentage, is the capitalization rate of the property. The cap rate of an asset is often an important metric analyzed by appraisers in the determination of value of a commercial property. In fact, it’s actually the key metric behind the income capitalization approach to property valuation.
Cap Rate Calculator
How To Calculate a Cap Rate
The cap rate can be determined using the following formula:
Capitalization Rate = Net Operating Income ÷ Current Market Value or Purchase Price
To better understand how to calculate cap rate, imagine a commercial property with a net operating income of $750,000 at a market value of $10 million. This property would have a capitalization rate of 7.5%.
Cap Rate = $750,000 ÷ $10,000,000 = 7.5%
The formula can also be used by substituting an investment property’s purchase price instead of using the current market value. Same formula can be used to calculate Cap Rate for a rental property. This can help investors determine the potential profitability of one asset compared to another.
How To Calculate the NOI for a Cap Rate
To calculate the NOI for a cap rate, you will need to take the following steps:
- Determine the property's value
- Subtract the mortgage balance from the property value
- Subtract any vacancy and collection losses from the property's potential gross income
- Subtract all operating expenses from the property's potential gross income
- Subtract any debt service from the property's NOI
The result will be the property's NOI for a cap rate.
It's important to note that the NOI does not include any debt service, such as mortgage payments or interest. This is because the cap rate is intended to measure the property's profitability on an unlevered basis.
NOI Calculator for the Cap Rate Formula
Understanding the Capitalization Rate and Its Applications
The measurement of an asset’s cap rate is arguably the most widely used method for lenders and investors to assess the profitability and return potential on a commercial real estate investment. Cap rates can also be used as a good indicator of the potential length of time it will take an investor to recover a staked amount in an income-producing property. As an example, consider a property with a cap rate of 10%. This metric reflects that it would take around 10 years for an investor to recover the full investment amount. An investment with a 5% cap rate would take around 20 years, and so on. Note that the eventual sale of an asset is not included in these calculations.
Additionally, the relationship between an asset’s NOI and its cap rate can be used to estimate the property’s value. An investor must have a good idea of the cap rates of similar properties — they should be commercial assets of similar vintage and class — as well as the prices they are trading for in that submarket.
Limitations of Cap Rates
Though a simple and useful formula and metric, cap rates should not be calculated the same way in every situation. For example, if you acquired a property several years ago, any cap rate based off of the sale price will likely be misleading due to changing property values. This holds true for value-add purchases as well, given the infusion of extra capital outside of the sale price. Similarly, don’t use a sale price for your cap rate calculation if it is a non-arm’s length deal, as this wouldn’t reflect market value. In these situations, it is much safer to use the current market value of the property.
While cap rates can be useful for lightly comparing the relative value of similar properties in a market, it isn’t necessarily a good indicator of an investment property’s strength because certain key factors such as leverage aren’t taken into account. Additionally, future increases in cash flows and the time value of money are not taken into consideration for cap rate calculations.