There are two pieces of information that real estate investors need in order to calculate a CAP rate or Capitalization Rate:
- NOI or net operating income of the asset
- Sales price or current market value of the asset
CAP rates are useful for comparing the performance of a real estate investment to similar properties in the market, to calculate what a sales price should be based on the property’s NOI, and determining what the net operating income should be based on the CAP rate of a property that’s for sale.
The CAP rate calculation can be used for residential and multifamily property, commercial investments, and even land.
Formula To Calculate A CAP Rate
The formula used in a CAP rate calculation is pretty straightforward:
CAP Rate = NOI / Sales Price
Let’s say we have a small multi family rental property investment that is generating $100,000 in net operating income each year. The owner decides to sell and lists the apartment building for sale for $2 million.
The CAP rate is: $100,000 NOI / $2,000,000 Sales price = 5% CAP rate
Why Is A CAP Rate Used?
In addition to comparing alternative real estate investments in the same market, the CAP rate formula can also be used for calculating what a sales price should be and in determining what a property’s net operating income should be based on CAP rates for similar properties.
For example, if our apartment building above is listed for sale with an asking price of $2.5 million and market CAP rates for similar properties are 5%, then the property’s NOI should be:
$2.5 million x 5% = $125,000 per year
Based on the capitalization rate calculation the property is over priced compared to its peers. Now, maybe there’s a good reason for this or maybe not. That’s up to the buyer and seller to determine.
What Is A Good CAP Rate?
CAP rates for specific asset classes vary from market to market and sometimes even from neighborhood to neighborhood.
A good CAP rate for one investor will be a not so good CAP rate for another investor. That’s one reason why it’s dangerous to call a CAP rate good or bad in and of itself.
But capitalization rates are useful for quickly comparing one real estate investment to another, and also return on investment for specific asset classes from one market to another.