Investing in rental property is an excellent way to pave the road to financial freedom, assist your retirement, or just enjoy the cash flow. Understanding how to measure cap rate for your property is helpful when evaluating properties and determining if the property is the right investment for you. In this article, we’ll discuss what cap rate is and how to calculate it.
What Is Cap Rate?
Cap rate, or capitalization rate, not only helps an investor evaluate and see possible future profits but also helps determine the risk level and possible financial loss of investments. Commercial investors use it when dealing with multiple investments. The capitalization rate shows the likely rate of return on a real estate investment after predicting rental profits.
Why the Cap Rate Is Useful
Investors use tools like the cap rate when making financial decisions, rather than simply guessing what they’re getting into and what the likely outcome looks like. Will the property investment generate a profit? That’s the question the cap rate helps answer.
Calculating Cap Rate
Here’s what the equation for capitalization rate looks like: net operating income/property asset value = cap rate. Let’s look at an example:
The net operating income (NOI) of a property is $100,000, and the property asset value is $1,000,000. Using NOI/property asset value = 10 percent cap rate (rate of return).
Before finding the cap rate, an investor must determine the net operating income. NOI is the difference between gross rental income and all the expenses it takes to operate the rental. It’s not as clear as the property asset value and needs calculation. Here’s what you need to calculate NOI:
- Gross income from rental
- Property insurance
- Property tax
- Repairs and maintenance
- Other expenses
The last six are subtracted from the gross income from the rental to give us net operating income.
Once an investor understands how to measure cap rate for a property and sees how helpful it is, the process becomes easy. It’s best to keep all receipts filed away throughout the year and write down any expenses that help calculate NOI, so when the time comes to calculate cap rate, you’re prepared.
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