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What Is Cap Rate – Formula & Definition

Posted by admin on October 6, 2022
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What Is Cap Rate – Formula & Definition

The capitalization rate, or cap rate, is a handy tool for estimating the rates of return on multiple commercial real estate properties. Learn how to calculate cap rates using our guide.


When you are looking to buy a bundle of real estate all at once, it’s important to have a few metrics that help you quickly estimate the potential profitability of the purchase. Commercial real estate purchases often involve this kind of grouped acquisition, which may involve buying multiple properties from the same seller or multiple properties in a similar location to build your portfolio.


One of those essential metrics to gauge the wisdom of your multi-property purchase is the cap rate. Today, we’ll dive into the meaning of a cap rate and the formula to calculate a cap rate on your own.


What Are Cap Rates

Cap rates estimate how well the income of each property capitalizes on the value. Therefore, the cap rate represents the rate at which the building will achieve its own capital value through income. This value is another way to look at the return on investment or ROI, but with a large-scale calculation that considers both the property’s potential to draw income and the current market value.


How to Calculate Cap Rates

  • Cap Rate % = (NOI / Property Value) * 100

The formula for cap rates is the Net Operating Income (NOI) divided by the property’s current market value, then expressed as a percentage.


How to Calculate NOI

Your net operating income, or NOI, is calculated by determining the total potential income of a building minus the operational expenses. Calculating your NOI annually rather than monthly is recommended for the most accurate estimate, including annual costs or fees.


Calculate the commercial rent earned by the building plus the potential income from fees or amenities like reserved parking. Then subtract your annual maintenance and loan repayment costs to reach your NOI


Determining Your Property Value

While some use the latest sale price, we recommend using the current market value of a property when calculating the cap rate.


Take your NOI and then divide it by the current market value of the building.


Do the Math and Make it a Percentage

For example, if your income is $120,000 a year, upkeep is $15,000 a year, and the property value is $400,000, then your cap rate calculation would be [(120K – 15K) / 400K] * 100 = 26.25%


What are the Factors that Can Impact Cap Rates?

  • Location’s impact on income and property value
  • Market size impact on income and competition
  • Asset stability impact on reliable income/costs
  • Capital liquidity impact on NOI


Defining a “Good” Cap Rate

Cap rates cannot be categorized as “good” or “bad.” Instead, think of the cap rate as the speedometer on your car. A high cap rate indicates properties that have high income but low value. They will pay themselves back and overcome your ROI quickly, but also generally pose a higher risk.


Low cap rates indicate the lower income and higher property values. A low cap rate is considered lower risk and potentially more stable but will pay back your investment more slowly. Knowing your investment priorities and risk tolerance is important when determining if a cap rate is good or bad for you.


Commercial Real Estate Experts in Denver, CO

Successful investments in commercial real estate require an expert team on your side. If you are looking for Denver-local experts in commercial real estate, you’ve found us. Here at Unique Properties, we know that every property and group of properties will be a unique investment. We’re here to help you make the best decisions for your real estate strategies, current finances, and growing portfolio. Contact us today to explore how our commercial real estate expertise can benefit your investment plans.


Image Credit / Shutterstock / Andrii Yalanskyi

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