how to calculate a cap rate on a rental property
The cap rate in real estate investing refers to the unlevered yield on an asset, based on its annual net operation income (NOI).
Cap rates are often compared with the coupon on bonds because both can be used as a way to express payment as percentage of asset value.
Many advisors will tell an investor that a higher caprate is better. The truth is that the higher cap rates are more likely to yield higher returns. But cap rates can't be everything. A property purchase decision should consider factors such as investor risk appetite and property location. Opportunities with low cap rate investment might be worth looking into for certain risk-averse investors.
The cap rate in real estate investing refers to the unlevered yield on an asset, based on its annual net operation income (NOI).
Simple formula to calculate a cap rate: Cap rate is the annual NOI divided the market price of the property. A property worth $10 million that generates $500,000 of NOI, would have a cap-rate of 5%.
Cap rates are a proxy for deciding which investment is better or less risky. A lower caprate will generally indicate a safer or more-risky investment. Conversely, a higher caprate will mean greater risk.
The same cap-rate formula can be used for estimating the value of a property based upon its NOI. As shown in the above example, if you know that the property is producing $500,000 in NOI and the appropriate rate (i.e.., unlevered yield) for a similar project is 5% you can divide $500,000 times 5% to get a $10,000,000 value. An $8.3 million project might only be worth 6% if there is an appropriate market rate. This is a good example of how shifting return expectations (in this case the caprate) can cause implied property values to fluctuate.
Cap rates, expressed as percentages, represent the return for a single point in the future. They are used for the evaluation of individual investment properties and to compare properties.
