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How to Determine Cap Rate for Investment Properties

Whether you're considering purchasing a small investment home or a bigger commercial property, it will be really crucial to determine the cap rate prior to making any offers.

cap rate calculation

Capitalization rate, better known as a "cap rate", is used to measure the return on investment that a property yields per year. Or in simpler terms, if you will be able to make money off of an investment property that you purchase.

How to Calculate Cap Rate

Cap rate is determined by dividing a property's annual net operating income (or NOI) by its current market value (price).

how to calculate cap rate

The best way to figure out the annual net operating income of a property is to look at how much was made over the course of one year (gross income). Then take that amount and subtract all of the operating costs associated with maintaining the property. These costs may include upkeep or maintenance of the property; HOA fees, utilities, property taxes, and insurance, etc. The amount you are left with is the NOI or "net operating income" of your property.

Next, you must figure out an accurate purchase price. This is actually much easier than you may think. Simply review recent sale prices of comparable properties in the area that have sold in the last 180 days. This will allow you to better decide upon an accurate value.

Now that you have the two cap rate variables, divide the annual net operating income by the price... and voila! You have the magic number we understand as a cap rate. Easy peasy!

how to calculate cap rate

What type of properties is cap rate used for?

Cap rates are most accurate when used for rental properties such as:

  • Apartment buildings
  • Townhouses
  • Multifamily properties
  • Single-family homes
  • Commercial properties

What is a "good" cap rate?

A cap rate between 4% and 10% is usually considered to be a good rate. However, keep in mind that factors such as demand, available inventory and property type can all affect a cap rate.

In general, the higher a cap rate the higher the risk. So a property with a 5% cap rate is going to be lower risk for an investor than a property with a 9% cap rate.

It's also important to consider the location of the property in relation to the rate. For instance, a 4% cap rate may be great given the property is in a more rural area whereas that rate may be viewed on the lower side in a busy metropolitan area.

how to determine cap rate

When Cap Rate Shouldn't Be Used

Cap rates are a valuable tool when determining if a property is a good investment but it shouldn't be the ONLY tool you use when evaluating a property. Plus there are some scenarios where determining a cap rate won't apply:

  • When a property is less than 5 years old
  • A house you are planning to flip
  • Short term investment properties
  • Land

Learning how to determine a cap rate for a prospective property is a very important step when considering an investment property. Not only will it help you figure out if the property will make a return on investment (and just how much) but it can also save you from making a poor investment decision.

It's a great idea to practice calculating cap rates so that the next time you're serious about an investment property you can quickly determine if the property is the right investment for you.

Happy Investing!

Want more advice about all things home — including homebuying or selling advice? Nestiny is a great place for homebuyer education and to help you gauge how ready you are to buy a home. Journey Homeward allows you to enter all your wants and needs while the True Affordability Tool will break down your budget, showing what you can comfortably afford. You will also receive a Ready Report that will give you a vital head start in the home buying journey, saving you valuable time and money.

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Ready To Become A Smarter Homebuyer?

By signing up, you agree to Nestiny terms of use .
Whether you need a step-by-step guide, video resource or one of our many helpful tools, Nestiny has your back 24/7 for all things home buying and selling. You choose the pace, material, and when and where to learn. Unlock your free access to Nestiny today!
Are you a real estate professional? Go here .
By clicking this button, you'll enjoy free unlimited access to Nestiny and agree to our terms of use . And don't worry! Nestiny will not share your information with any parties without your consent.