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Real estate investors use the capitalization rate, or cap rate, to determine if a potential investment property shows enough potential return on inves

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Real estate investors use the capitalization rate, or cap rate, to determine if a potential investment property shows enough potential return on investment (ROI) to make it a valuable purchase. It is based on annual returns, so if a property has performed well or poorly for one year, it will be reflected in its calculation. The limit rate is calculated using the formula below, expressed as a percentage:

Cap rate = Net Operating Income (NOI) / Current Property Value

Cap Rate Calculator

Use the calculator below to calculate a property’s limit rate:

Let’s look at a quick example of how to calculate NOI. Your gross rental income is $ 60,000, your occupancy rate is 85%, and your operating expenses are $ 15,000.

$ 60,000 x 85% = $ 51,000

$ 51,000 – $ 15,000 = $ 36,000 NOI

Cap Rate Examples

Below are two cap rate calculations based on two different properties. This will show you that the more expensive property is not necessarily going to have the better limit rate.

Property A

  • Property value: $ 850,000
  • NOI: $ 56,080

Property B

  • Property value: $ 700,000
  • NOI: $ 48,560

Divide the NOI by the property value to get the limit rate

  • Property A: $ 56,080 / $ 850,000 = 0.066
  • Property B: $ 48,560 / $ 700,000 = 0.069

Because the cap rate formula is expressed as a percentage, now multiply by 100:

  • Property A: 0.066 x 100 = 6.6% limit rate
  • Property B: 0.069 x 100 = 6.9% limit rate

Despite the fact that property B is cheaper, it has a higher limit rate, so it will be the better purchase just based on the limit rate. This is why, before you buy, you need to look at the overall financial picture of the investment property, including ROI, cash flow, and for which comparable properties are being sold and leased.

What is a good cut rate?

A good cut rate is just over 4%. The higher the cut rate, the higher the financial return the property will have. The lower the limit rate, the lower your ROI will be, and you may want to consider another investment property.

However, a lower limit rate also means that the property is a safer or lower risk investment, while a higher limit rate means more risk. Understanding what the limit rate is, how it works, and alternative calculations for evaluating financial potential is critical before purchasing a new investment property.

Since the limit rate does not take into account mortgage payments or the costs associated with purchasing the property and is merely a snapshot of the property over one year, the investor does not necessarily get the full picture of the property’s performance over several years. So, while it is a good tool to use, it is important to know the factors that can affect the limit rate, including

  • Location: Property in a more desirable location will probably cost more to buy, but rents will also be higher. This is why you should use the limit rate, because property in a desired location can have the same limit rate as one in a cheaper location.
  • Bate type: Commercial properties tend to have higher limit rates than multi-family properties, apartment buildings and residential properties because commercial properties tend to have higher rental rates.
  • Available stock: The lower the inventory, the higher the demand, leading to properties with lower cap rates.
  • Interest rates: Rising rates tend to mean a drop in property values. Rising rates also increase debt, which reduces net cash flow. As a result, rising rates can lead to lower cap rates.

When to use the cut rate

Cap rate is mainly used by long term investors who want to buy property for rental purposes. In addition to long-term investors, landlords and commercial investors will consider the limit rate when evaluating a property.

Use the limit rate for

When not to use the cut rate

The limit rate calculation does not work for every investor and situation. If you are repairing and turning around or buying vacant land, you are not renting the property, so the limit rate does not affect your purchase decision.

In general, you will not consider the limit rate in the following scenarios:

  • Fix and turn: You sell the property for profit once it is repaired, so you do not consider rental income potential when buying a property.
  • Buy land: You can not calculate rental income or NOI on vacant land, so the limit rate does not apply here. Before you buy undeveloped land, check out our guide to buying land.
  • Buy a holiday rental property: Because the property may not be let through the entire year, the limit rate will not give an accurate representation of the value.
  • Short term rental property: Because the property is rented out for short periods, and the limit rate is calculated based on annual income, the limit rate is likely to be skewed.

Alternative Ways to Evaluate Investment Property

As mentioned above, there are other ways to evaluate investment properties. Be sure to consult with your financial advisor and consider various real estate performance criteria before making a purchase. Other evaluation methods include

  • Similar features: Compare selling prices for comparable properties in the area to determine the value of a potential property.
  • Price per unit: Divide the potential purchase price by the number of rental units in the building.
  • Cash flow: Calculate the amount of expected rental income, and deduct expenses such as mortgage payments, taxes, insurance and utilities to determine overall cash flow.
  • Gross rental income: Divide the annual rent collected by the total property cost, and then multiply by 100 to determine the gross rental income. The total property costs include purchase price, closing costs and renovation costs. Anything above 7% is a good rental return.
  • The one percent rule: The gross monthly income must be a minimum of one percent of the purchase price. If the gross monthly income is one percent or more of the purchase price, the property will usually have a positive cash flow.
  • ROI: Divide your annual return by your total cash investment. Annual return is calculated by deducting expenses from your total rental income. An ROI of more than 10% is good for real estate investing.

Bottom Line

Before buying an investment or commercial property, calculate your potential limit rate to determine if the property is a good investment. Although cap rate is a good tool, it should be just one of several factors to consider when buying real estate. Consult your financial advisor during the evaluation process.

If you decide to take out a loan to buy an investment property, check out our guide on how to get a small business loan to help you get started.

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