Instantly See the Capitalization Rate of Your Rental Property with This Easy Calculator

What Is a Cap Rate?

The cap rate, short for capitalization rate, is a popular metric of profitability in real estate investing that measures the return on investment over a certain year, usually one year. It is a simple way to evaluate how much money a rental property earns compared to its purchase price or current market value (CMV).

In addition, the cap rate also measures the level of risk associated with a real estate investment. Higher cap rates may suggest higher returns but also higher vacancy rates or management costs. Meanwhile, a lower cap rate might indicate safer, more stable markets.

The cap rate can be used for both short-term and long-term rental properties.

Cap Rate vs Rental Yield

Real estate investors need to use both the cap rate and the rental yield when evaluating the profit potential of an investment opportunity. While both metrics measure return, there are major differences between the two.

The cap rate calculation is usually based on the current market value of the property, while the rental yield is calculated using the purchase price. Even more importantly, the cap rate doesn’t consider the cost of financing (mortgage payments), whereas the rental yield takes the financing fees into consideration.

This makes the cap rate an easier, albeit less comprehensive metric, to evaluate and compare both markets and investment properties for sale.

Understanding the Importance of Cap Rate in Real Estate Investments

Using the cap rate brings many important benefits to real estate investors including:

1. Easy Market Comparison
   
   The cap rate can be calculated at the market level for a quick, yet efficient rental market analysis. Because it captures rental income, operating expenses, and real estate prices, it is a comprehensive measure that can draw a thorough picture of the current state of the entire market where you plan to invest.
   
   Moreover, because it doesn’t incorporate financing, it is easier and faster to calculate than other ROI metrics in real estate.
   
   With the help of the cap rate, you can easily compare different markets to choose the best Airbnb market for profitable investments.
   
   
2. Straightforward Property Analysis and Comparison
   
   Similarly, the cap rate allows you to compare the profit that you can expect from different rental properties for sale when deciding which one to buy. The metric helps you identify the investment opportunity that will bring the highest return compared to the purchase price.
   
   
3. Investment Risk Assessment
   
   When investing in a real estate property, it’s important to consider not only the profit but also the risk, and the cap rate helps you do that in an easy way. A higher cap rate is associated with a more risky investment, while a lower cap rate means a less risky investment.
   
   Using the cap rate, you can select the property that corresponds to your comfortable level of investment risk while still generating good returns.
   
   
4. Putting Profit Into Context
   
   Finally, the most important advantage of the capitalization rate compared to other measures of profitability is that it combines return and risk into a single metric. In this way, you can strike the right balance between investment return and risk for a comfortable, yet profitable opportunity.

How to Calculate Cap Rate on a Rental Property

To calculate the cap rate of a real estate asset, you need to follow these steps:

1. Calculate the net operating income (NOI) of the property by subtracting the operating expenses from the gross operating income.
2. Divide the NOI by the property’s current market value.
3. Express the number as a percentage.

Calculating the cap rate is done using the following formula:

Formula to Calculate Cap Rate

Cap Rate Formula

Cap Rate = Net Operating Income (NOI) / Current Market Value x 100%

Where

• Net operating income (NOI) refers to the difference between the gross operating income (total rental income) and the costs associated with running and managing the property, excluding mortgage payments and taxes
• Current market value is the present value of the property in the market

Applying the cap rate formula is easy as long as you have the necessary data on the performance of the rental property.

To make things clearer, let’s take a look at a specific example.

Cap Rate Calculation Example

A short-term rental property generates a revenue of $60,000 per year. Operating costs excluding mortgage payments and taxes amount to $15,000 per year. The property is worth $750,000 in the current market.

• Net Operating Income (NOI) = $60,000 - $15,000 = $45,000
• Cap Rate = $45,000 / $750,000 x 100% = 6%

So, the capitalization rate of this Airbnb rental property is 6%.

What Is a Cap Rate Calculator?

The cap rate calculator is a real estate investment analysis tool that helps calculate the cap rate on a rental property in a quick and easy way. It minimizes the need for manual calculations to eliminate error and speed up calculations. This tool makes the analysis and comparison of real estate markets and investment properties more efficient.

How Do You Calculate Cap Rate Using a Calculator?

Using the cap rate rental property calculator requires the following steps:

1. Find the net operating income (NOI). To determine the NOI of the property, add together all operating costs including inspection fees, maintenance, pest control, property management fees, insurance, utilities, and everything else that goes into owning and renting out an income property. Do not include the mortgage payments. In addition, get the gross operating income, which is the total rent that you get from the property over the course of one year. Subtract the operating expenses from the operating income to get the net operating income.
2. Get the current market value of the property. If you purchased the property a few years ago, you’d need to perform comparative market analysis to find out what real estate comps (properties similar to yours) are listed for.
3. Input the NOI and current market value numbers into the cap rate calculator.

The calculator will show you the cap rate as a percentage that you can use to compare this property to the average market performance as well as to specific properties. In this way, you can choose the most profitable opportunity if you’re buying a rental property. In case you already own an income property, you can compare its performance to comps to make sure you are not leaving money on the table.

What Is a Good Cap Rate for Rental Property?

Typically, a good cap rate for rental properties is considered between 5% and 10%. However, the capitalization rate depends on multiple factors, such as the market, the property type, the general investment climate, and others. When deciding if a certain level is good for a property you’re considering buying, you should compare it to the market average and your selected rental strategy.

When distinguishing between long-term and short-term rentals, the latter are usually associated with a higher cap rate, where good values reach up to 12%. This is because vacation rentals bring more risk, such as vacancy and regulations. The higher average profit is required to offset this balance and make Airbnb the lucrative real estate investment strategy that it is.

5 Factors Affecting the Cap Rate

The capitalization rate of a real estate rental property is determined by a number of market- and property-specific factors, including:

1. Location
   Location is the #1 factor impacting the capitalization rate of a property. Top markets with strong demand and stable rental rates are characterized by low cap rates as investors are ready to accept less return in exchange for a safer investment with minimal risk.
   To the contrary, emerging markets with growing opportunities provide higher profit as investors need a better cap rate to compensate for the higher level of investment risk. That’s why the market-average cap rate is the first value that you should look at when evaluating an investment opportunity to see if the property has the potential to outperform or underperform the market.
2. Property Type
   The type of rental property is another factor that affects the capitalization rate. Generally speaking, residential properties have lower cap rates than commercial and industrial properties. This is because while residential properties bring less income, it is more stable. With commercial and industrial properties, the return might be high, but the risk is also high in case you are not able to rent out the property.
3. Property Condition
   New rentals in a good condition yield lower returns than older houses in a poor condition. Once again, the lower level of risk associated with better maintained properties dictates the less favorable profit potential.
4. Rental Strategy
   On average, short-term rentals generate more profit, which means that they enjoy higher cap rates, than long-term rental properties. The reason is simple. Airbnbs yield higher rental income because they are rented out on a daily basis, so rental rates are higher. However, the risk is also significantly more pronounced as you need to continuously market them and dynamically price them to get bookings.
   On the other hand, once you rent out a long-term rental property, you are likely to have it under contract for at least one year. This lower vacancy risk and less significant maintenance and marketing costs comes with a lower cap rate.
5. Market Conditions
   Macroeconomic conditions as well as the state of the local real estate market influence the level of cap rates too. Real estate supply and demand, rental trends, and housing inventory affect rental income, operating expenses, and property prices, which together make up cap rates.
   Additionally, when the economy grows and interest rates go down, the demand for homes goes up, which elevates real estate prices. In turn, this puts a downward pressure on the cap rate.

5 Cap Rate Limitations

Although the capitalization rate is a helpful measure to evaluate profitability and compare markets and properties, it is not a perfect real estate metric. It has certain restrictions, so it should be used in combination with other measures such as rental yield and cash on cash return to get a comprehensive analysis of a real estate investment opportunity.
The main limitations of the cap rate include:

1. Doesn’t Take Into Account Financing
   The main issue with the capitalization rate is that it doesn’t consider the financing method. The truth of the matter is that in most cases, real estate investors use financing, whether a mortgage, hard loan, private money loan, or another method, to finance the purchase of a rental property. How much you spend on the investment initially and over the course of the years affects your cash flow and return.
   By not including this factor, the cap rate becomes easier to calculate but also a less comprehensive measure than other ROI metrics.
2. Ignores Appreciation and Depreciation
   The cap rate looks at the current net operating income relative to the property’s value. It fails to account for potential changes in rental income and market value over the years. Sometimes a property might have a low cap rate but appreciate in value over the years, which might still make it a worth it investment.
3. Doesn’t Look at Trends
   The capitalization rate is a static metric which takes a snapshot of the current state of matters. It doesn’t take into account changes over time. This means that it doesn’t show how a rental property investment performs over its lifetime.
4. Has Little Use Beyond Comparison
   The cap rate is a great way to compare markets and properties that are of the same type and size. However, it has very limited meaning beyond this comparison. A value of 8%, for example, doesn’t tell us much about the profitability of a rental property unless compared to the market average and comps in the area.
5. Requires Reliable Data to Be Accurate
   Another major limitation of the cap rate from the point of view of investors is that it requires a lot of data points to be calculated. Although there are only two variables in the cap rate formula - the net operating income and the current market value, calculating the NOI and estimating the property value demands complex assumptions and data sets.
   While the cap rate calculator speeds up calculations, it doesn’t provide readily available cap rate calculations.