How Are Cap Rates Calculated?

[Justin Goodin]

There are multiple ways to come up with a cap rate, so be sure to always ask how it was calculated.

Most cap rates are calculated by taking the net operating income and dividing it by the market value. Cue the example for clarity -

Cap Rate Example

Let’s talk about a property valued at $1 million. Over the past year, it’s brought in $100,000 in rental income.

After paying $50,000 in expenses, we wind-up with $50,000 in Net Operating Income (NOI).

We take the NOI of $50,000 and divide that by the total value of the property.

$50,0000 / $1,000,000 = 5%

This means if we bought that property with $1 mil right now, we could expect to earn $50,000 net income over the course of one year. This, loosely, is your Return on Investment or ROI.

One way to think about it is that it would take 20 years of returns at $50,000 to recoup your $1 million initial investment.

If the property generated $150,000with the same $50,000 in expenses, the cap rate would be $100,000 divided by $1 mil, which would equal 10%. In that case, it would only take 10 years to recoup your initial investment value.

The higher the cap rate, the faster you’d earn back your investment capital, and the better the investment choice. The good news is, you don’t need to know all the specifics in order to see success as a passive investor.

[Mitch Messer]

Originally posted by @Justin Goodin:

There are multiple ways to come up with a cap rate, so be sure to always ask how it was calculated.

Most cap rates are calculated by taking the net operating income and dividing it by the market value. Cue the example for clarity -

Cap Rate Example

Let’s talk about a property valued at $1 million. Over the past year, it’s brought in $100,000 in rental income.

After paying $50,000 in expenses, we wind-up with $50,000 in Net Operating Income (NOI).

We take the NOI of $50,000 and divide that by the total value of the property.

$50,0000 / $1,000,000 = 5%

This means if we bought that property with $1 mil right now, we could expect to earn $50,000 net income over the course of one year. This, loosely, is your Return on Investment or ROI.

One way to think about it is that it would take 20 years of returns at $50,000 to recoup your $1 million initial investment.

If the property generated $150,000with the same $50,000 in expenses, the cap rate would be $100,000 divided by $1 mil, which would equal 10%. In that case, it would only take 10 years to recoup your initial investment value.

The higher the cap rate, the faster you’d earn back your investment capital, and the better the investment choice. The good news is, you don’t need to know all the specifics in order to see success as a passive investor.

This is not quite accurate: Cap rate completely excludes renovation costs and capital expenditures, so it cannot tell me my actual return on investment.

Cap rate is most helpful when seen as a measure of a submarket, rather than having meaning for a single property. It's pretty much like price-to-earnings ratios for a specific stock market sector: Just because the P/E is high doesn't necesarily mean a stock is a good investment.

This blog post by Brian Burke@Brian McPheetersdoes the best job of explaining cap rate that I've seen yet: https://www.biggerpockets.com/...