What is Cap Rate in Real Estate Investing?

what is cap rate in real estate

Last updated on January 15, 2022

If you've spent any amount of time in the real estate space, then you've heard of the term 'cap rate'. Real estate enthusiasts and investors use this term often when discussing which properties to acquire. Let's dive into understanding what exactly cap rate is and how to apply it.

Calculating Cap Rate

Cap rate is short for 'capitalization rate'. There are multiple ways of doing so, but in short is calculated by dividing the the net operating cost of the rental by the current market value of the rental property. The net operating cost can be calculated by taking the expected annual revenue generated by the property minus any property taxes and maintenance costs. To make sure we fully understand this, let's follow a simple example following an investor.

Cap Rate Calculation Examples

Our investor finds two potential properties. The first property's market price is $500,000. The investor learns that they can expect the first property to bring in a gross annual revenue of $45,000, and that they can expect maintenance costs and property taxes to total $15,000 per year. Plugging these numbers into the above formula would have us taking the sum of $45,000 minus $15,000 of $500,000 and dividing by $500,000. This brings us to a calculated cap rate of 6% for the first property.

Let's run through the second property. Our investor sees the second property on the market for $800,000 and learns that the expected annual revenue is $90,000 and the property tax and maintenance costs will be $20,000. This will produce a cap rate of 8.75% for the second property.

How to Use Cap Rates in Real Estate Investing

Now that our investor has calculated the cap rate of these two different properties, they understand that they can expect about a 6% rate of return of the first property, and an 8.75% rate of return on the second property. The investor is ostensibly looking for the maximum rate of return so the second property would appear more attractive.

Arriving at the cap rate for the potential rental properties you've got in your scope can help you make the best choices when it comes to maximizing your returns when investing in real estate. Not only will it help distinguish between potential investment properties, it can give you a better perspective if you're deciding whether to sink your money into real estate versus other types of investments such as stocks and bonds.

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