Once you understand this formula and its importance, you should learn how to calculate cap rate. The cap rate formula is relatively straightforward:
Capitalization rate = net operating income / current market value
Not sure what all that means? Let’s break it down:
- Net operating income is the annual income you expect to make from the rental property.
- Current market value is what you could expect to sell the property for in today’s real estate market.
In general, a cap rate of between 4% and 10% is considered good, though the actual number will depend on how comfortable you are with risk.¹ The higher the cap rate, the more risky the investment is. A seasoned investor may be more comfortable with a higher cap rate than a risk-averse investor or a first-time landlord.
1. Determine net operating income
The first step in figuring out the cap rate is calculating net operating income. To do so, subtract your operating expenses from your gross income.
Your gross income is the money you expect to make yearly from rent. This will be an estimate, though if you already own the property, you can look at past years’ income to make a more informed estimate.
Expenses include real estate taxes, maintenance, property management fees, and insurance.
For example, a rental property that brings in $18,000 in annual income and has total yearly expenses of $5,000 will have a net income of $13,000 ($18,000 gross income – $5,000 expenses = $13,000 net income).
2. Divide by current market value
Once you have determined the net operating income, divide that number by the current market value of the property or asset.
Say the property with $13,000 in net income has a current market value of $150,000. The calculation for this property would be $13,000 / $150,000 = 0.087.
3. Express as a percentage
To determine the cap rate, multiply the above number by 100 to reach a percentage. In this case, the $150,000 property with $13,000 in net income has a cap rate of 8.7% (0.087 x 100, expressed as a percentage).
