A cap rate calculator helps investors evaluate the profitability of a property.
Here’s a free cap rate calculator tool you can use, along with a guide explaining what capitalization rate is, how it works and how to apply it to make more profitable investment decisions.
Capitalization Rate: What Is It?
The capitalization rate, or the cap rate, measures what kind of return on investment a real estate investor can expect from an investment property. It compares the income generated by a property (net operating income) with the property’s current market value. The resulting ratio, expressed as a percentage, predicts the rate of a return an investor can expect from the property.
Investors use the measure to determine whether a property represents a profitable investment. A real estate cap rate calculator can help investors spot worthwhile opportunities while steering them away from properties likely to yield little return or a loss.
The Cap Rate Formula
The basic formula used by a cap rate business valuation calculator is fairly simple. You obtain a ratio by dividing net operating income (NOI) by current market value (CMV), and then you multiply the result by 100 to express it as a percentage:
NOI / CMV * 100
For instance, let’s say a property’s net operating income is $18,000 and its current market value is $200,000. The cap rate would then be 9%:
$18,000 / $200,000 * 100 = 9%
This represents your expected return on investment from the property over the course of a year.
An online cap rate calculator can crunch these numbers quickly as long as you know what data to enter. Let’s take a closer look at what net operating income and current market value are and how to determine them when using a simple cap rate calculator.
Net Operating Income
To determine net operating income (NOI), you need to know a few variables:
- The gross rental income (GRI) you would earn if all units in the property were occupied
- The occupancy rate (OR), representing the average percentage of units occupied at any given time
- Your operating expenses (OPEX)
To determine the net operating income, multiply gross rental income by occupancy rate, and then take the result and subtract your operating expenses:
NOI = [GRI * OR] – OPEX
For instance, if gross rental income is $120,000, occupancy rate is 75%, and operating expenses are $30,000, net operating income is $60,000:
($120,000 * 75%) – $30,000 = $60,000
Most property owners calculate gross rental income monthly. You can multiply your monthly gross rental income by 12 to get your annual gross rental income.
Occupancy rate applies for properties with more than 1 unit. If a property only has 1 unit, your occupancy rate is 100% when the property is occupied, which is the same as multiplying by 1, so you can just use gross rental income in this case.
Operating expenses include items such as:
- Management fees
- Maintenance and repairs
- Legal fees
- Miscellaneous expenses
However, mortgage payments normally shouldn’t be included as operating expenses. When you use a cap rate calculator on a property with mortgage payments, the mortgage is factored out of the equation as it would be difficult to estimate the value of the property. An exception to this is if your accountant includes your mortgage interest payments as an operating expense, handled separately from your principal payments.
Current Market Value
Current market value (CMV) is simply the fair market value (FMV) of the property, which is the price you would expect to get for a property if you sold it on today’s market.
You can determine this by asking a real estate agent for a comparative market analysis (CMA). The real estate agent will consider factors such as the property’s location, square footage and number of rooms and compare it with similar properties in the area to estimate its value. Most real estate agents will perform a comparative market analysis for free.
For a more accurate and authoritative evaluation, you can contact a licensed real estate appraiser, who will do a deeper analysis than a real estate agent. Appraisers charge a fee for this service.
For a very rough estimate of fair market value, you can use an online tool for estimating property value, such as Zillow’s Zestimate tool.
Note that you can reverse the results of a cap rate calculator to determine a property’s value. For instance, if you know a property’s annual net operating income and you know what cap rate similar properties have, you can use this information to estimate the property’s value.
When to Calculate the Cap Rate
Using a property cap rate calculator can generally be useful in a number of situations, including:
- Purchasing an apartment building
- Buying a single-family home, multifamily property, duplex, triplex or fourplex to rent
- Investing in a commercial property
- A new landlord seeking to evaluate your return on investment
Likewise, knowing your cap rate can be useful if you’re planning on selling any of these types of properties.
Keep in mind that calculating the cap rate isn’t especially useful when you aren’t planning to rent a property. For instance, if you’re flipping properties, you wouldn’t normally put an emphasis on cap rate.
When dealing with properties that involve long-term borrowing, such as commercial properties, you may wish to use an alternate way of calculating the return on an investment — the cash-on-cash return — and compare the results with what you get from using a commercial real estate cap rate calculator.
It’s also important to realize that the cap rate isn’t the sole determinant of a property’s value. The cap rate can be influenced by factors such as location and market trends. For a complete picture, consider the cap rate alongside other methods of evaluating properties.
Cap Rate: Rule of Thumb
How do you interpret your results when making investment decisions? Here are some general guidelines:
What’s a Good Cap Rate?
Real estate investors generally consider a cap rate of 4% to 10% as a good return on an investment, preferring properties with a cap rate of 10% or more. However, this can vary by market. For instance, what would be a good cap rate in a large city with expensive properties such as San Francisco might differ significantly from good cap rates in a market such as Indianapolis.
A forward-looking real estate investor should consider a property’s projected performance as well as its current cap rate. Cap rates can change as property values change. What might be a good investment today may not be as good tomorrow, while other properties that don’t look so promising today may rise in value in the future.
What’s a Bad Cap Rate?
Investors generally avoid a cap rate below 4%. Some avoid properties with a cap rate less than 10%. Consider your market as well as projected market trends.
Calculating the potential return of a property helps you determine whether it is a worthwhile investment.
Make Smart Real Estate Investments
Calculating the cap rate can help you make smarter investment real estate decisions by letting you know which properties are most likely to yield a good return on investment.
When you find a property that represents a good investment, it’s important to seize the opportunity. If you need financing to take advantage of a hot real estate investment opportunity, consider applying for a business loan or line of credit.