How to Figure Cap Rate on Your Real Estate Investment

One of the major ratios used by those investin in real estate is the capitalization rate. The capitalization rate, or cap rate as it is more commonly known, can be figured quite easily once you know the components that go into the calculation. The cap rate is essentially the rate of return on the value of a piece of real estate. It can be used to value a property prior to purchase or can be used to compare the expected return of various real estate investments or even compare investments in other areas such as stocks or bonds.

Difficulty: Moderately Easy

Instructions

Things You'll Need:

• Real estate for investment
• Calculator
• Information on fixed and variable costs for the property

1. Add up all the costs for the piece of property you are considering including all of the fixed costs and variable costs. These costs would include such things as real estate taxes, insurance, routine maintenance expenses, and depreciation to name a few.

2. Calculate the amount of expected income for the property for the year and subtract the total costs found in Step 1. Include all sources of revenue including leases and vending revenues. This should leave you with the net operating income.

3. Take the annual net operating income found in Step 2 as the numerator and divide by the market value of the property. This result will give you the capitalization rate for that piece of property. The cap rate can then be used to compare one piece of property against another to evaluate the potential profitability of the investment.

Tips & Warnings

• Be sure to include some allowance for expected vacancies when calculating the income and periodic maintenance expenses when calculating costs.
• Do not use the purchase price of the property to calculate cap rate if the purchase occurred several years ago or in a vastly different real estate market. This will give a false impression of the cap rate.