The Capitalization Rate (Cap Rate) is used by investors when analyzing investment properties. The cap rate represents the estimated percent of return an investor might expect when purchasing a property __all cash__ (debt related to principal and interest is not used in the cap rate calculation).

The cap rate is used when comparing a potential acquisition to other investment opportunities similar in nature. It gives a quick, general comparison of the earnings potential of an investment property.

Given the purchase price along with net operating income, one can determine the cap rate for a property. Similarly, using a desired or projected cap rate and knowing the net operating income, one can use the cap rate formula to estimate the value of an investment property.

Example 1 - Determine the Cap Rate

You want to purchase a triplex. You find one you like with an asking price of **$350,000**. Each unit rents for $1150 per month. 1150 x 3 (units) x 12 (months) = $41,400. Allowing for a vacancy rate of 4% yields a gross operating income of $39,744. Taxes + insurance + property maintenance = $11,000. Net Operating Income is $28,744. NOI ÷ Price = Cap rate. (28744/350000) = .0821 or 8.21%.

$41,400

(gross rent income)

__- $1656__

(vacancies allowance)

$39,744

(gross operating income)

__- $11,000__

(operating expenses)

$28,744

(net operating income)

**Cap rate is 8.21%** (28,744 ÷ 350,000 = .0821)

Example 2 - Estimate the Value of a Property

You want to purchase a duplex. You find one you like with an asking price of **$225,000**. Each unit rents for $1,000 per month. 1,000 x 2 (units) x 12 (months) = $24,000. Allowing for a vacancy rate of 4% yields a gross operating income of $23,040. Taxes, insurance and property maintenance = $7,500. This makes your Net Operating Income = $15,540. You know that similar properties in the area have sold with a Cap rate of 7.5% and you want to achieve that or higher. In this case you would take the NOI and divide it by 7.5%(.075). 15,540 ÷ .075 = $207,200.

$24,000

(gross rental income)

__- $960__

(vacancies allowance)

$23,040

(gross operating income)

__- $7,500__

(operating expenses)

$15,540

(net operating income)

**Value is $207,200** (15,540 ÷ .075)

At $225,000 it would appear this property is overpriced for what you want to achieve.

The Cap Rate calculator can be a great tool when attempting to measure the profitability of an investment. However, you should not rely solely upon the cap rate when deciding to purchase a property. Some things to consider include:

- The cap rate does not take take into consideration the age of a building. A property that is 40 years old is bound to have greater repair and maintenance costs than a property that is 5 years old.
- If you are purchasing a property in a market that is set to grow, it may be worth purchasing the property with a seemingly lower cap rate. Future rents may increase and the value of the property will likely appreciate.
- A lower cap rate may be acceptable when there is less risk associated with a property. For example, one vacancy in a duplex would have a greater negative impact than one vacancy in an apartment complex with 30 units.
- The cap rate does not account for financing costs.