Cap Rate or Capitalization Rate is a financial indicator that helps guide you in your decision to invest in a certain property. These financial indicators can be confusing and misleading.
To calculate the Cap Rate you first have to find out what the Net Operating Income (NOI) is for the building. This is simply your income minus your expenses (excluding debt service). What is left over is your NOI. Once you know your NOI, just divide it by the asking price of the property to get your Cap Rate. Let’s look at an example.
A building is listed for $300,000. It is a 6 unit apartment building and has rental income of $500 per unit which is $3,000 per month or $36,000 per year. Your monthly expenses are $2,000 per month or $24,000 per year. Therefore, your NOI would be $3,000 minus $2,000 =$1,000 per month or $12,000 per year. Your Cap rate is then $12,000/ $300,000 = .04 x 100% = 4%. The higher the Cap Rate, the better the deal.
There are some problems when looking at Cap Rate. First of all you should calculate your own Cap Rate. Owners tend to show expenses lower than what they actually are. For example they may leave out property management. The lower the expenses, the higher the NOI, the higher the Cap rate. So the Cap Rate looks better than it really is.
Some people use Cap Rates to determine the market value of a property. For example the going Cap Rate for properties in a certain may be 6% and the property you are looking at has a Cap Rate of 8% which may look like a good deal. This could be misleading because you still want to make sure the property cash flows and that you are going to get a good cash on cash return on your investment.
In this example if you bought the property with only 10% and you financed the balance of the purchase price at 4% for 35 years, your payments would be around $1,200 per month which means you end up with a negative cash flow of over $200 per month. If your NOI was $1,500 per month or $18,000 per year your Cap Rate would be 6% and you would now have a positive cash flow of $300 per month. This could change depending on mortgage rates and amortization period.
So, when looking at Cap Rates, make sure you calculate your own using all of the expenses. You can use estimates and market values for any expenses that are unknown. Use Cap rate as a starting point but always make sure your investment cash flows before making an offer.