Cap Rate Real Estate

Cap rate is an important metric used by real estate investors to compare investment returns between different rental properties, before income taxes and any potential financing.

Essentially, cap rate can be calculated by dividing the net operating income of a property by the investor’s cost basis in the property, where net operating income is gross rent less expenses and the cost basis of the property is the purchase price plus closing costs and any renovation costs.

Cap rate definition
Cap rate formula
Cap rate calculator
Cap rate example

Cap rate, short for capitalization rate, is a measure used in real estate to evaluate the potential return on an investment property. Simply put, cap rate is the percentage of the property’s value that is expected to be generated in income in a given year.

To calculate cap rate, you divide the property’s net operating income (NOI) by its current market value or cost basis. The NOI is the income the property generates from rental payments or other sources, minus any operating expenses such as property taxes, HoA dues or condo common charges, maintenance costs and insurance.

For example, let’s say you are considering purchasing a rental property for $500,000 that generates an NOI of $50,000 per year. The cap rate for this property would be 10% ($50,000 / $500,000). This means that the property is expected to generate a 10% return on your investment each year.

The above example is of course a simplification, as the NOI will technically be divided by an investor’s cost basis, which would consist of the $500,000 purchase price plus closing costs plus any renovations done post-closing.

Cap rate is an important tool for real estate investors because it helps them compare the potential returns of different investment properties.

The capitalization rate, or “cap rate” for short, is a commonly used metric in real estate investment analysis. The cap rate formula is a simple way to determine the value of an income-generating property by calculating the rate of return that an investor can expect to earn on their investment. The cap rate is calculated by dividing the net operating income (NOI) of the property by its current market value or cost basis.

The formula for cap rate is: Cap Rate = Net Operating Income / Cost Basis

Net Operating Income (NOI) is calculated by subtracting all operating expenses from the gross income generated by the property. Operating expenses include property taxes, insurance, utilities, maintenance, repairs, and property management fees. Gross income is the total income generated by the property, including rental income and any other revenue streams.

The cost basis is calculated by adding the purchase price (or prospective purchase price) to the buyer’s or potential buyer’s closing costs and the cost of any renovations done or to be done post-closing. Sometimes instead of cost basis, people will replace the denominator with current market value. This simply changes the calculation from the original cap rate at the buyer’s purchase price, to the current cap rate a prospective buyer today might encounter.

For example, if a property generates $100,000 in gross income and has $30,000 in operating expenses, the NOI would be $70,000.

Let’s calculate the cap rate for a real condo listed for Sale by Hauseit in Miami: 2900 NE 7th Ave, Apt 4105, Miami, FL 33137. It’s currently listed for $1,230,000 and the owner purchased it on 11/05/2021 for $940,000.

So as we discussed, we can either calculate the cap rate for the original purchase in 2021, or we can calculate a potential cap rate for a buyer today at the current market value.

Since we’ve already calculated the cash on cash return for this example listing using its current market value in another article, we’ll go ahead and calculate the cap rate using the original cost basis for the current owner.

First of all, we need to calculate the original cost basis, which is the buyer’s publicly recorded purchase price of $940,000 plus any renovation costs and the buyer’s Florida closing costs. We can see from a comparison of the current listing’s photos vs the original listing’s photos that the unit came in good condition, and no renovations were needed. Then we used Hauseit’s Miami Buyer Closing Cost Calculator to determine that the estimated buyer closing costs in 2011 were $6,910.

We can tell from public records (i.e. Miami-Dade Property Appraiser’s website) that the property taxes were $14,264.59 for the prior year.

Common charges are listed as $1,530 per month, which equates to $18,360 per year. We assume $850 for a home insurance policy, and 0% vacancy given the hot Miami market. Utility bills are $0 since utilities are either included in the common charges, or payable by the tenant. We’ll also assume a 0% management fee for a self-managed property by a small-time landlord. Since the property appears to be in great condition, we’ll also assume nothing breaks and $0 for maintenance and repairs.

Here’s what the return profile looks like using Hauseit’s Cap Rate Calculator:

Pro Tip: Given the healthy rental income at $7,500 per month, and the lower cost basis for the original buyer, he or she is able to enjoy a cap rate of ~6%. If the buyer is able to employ leverage at an interest rate lower than the cap rate, then he or she should be able to increase the property’s cash on cash return (or return on equity) even further!