Cap Rate Calculator
Determine the net gain or loss of profit on an investment over a specified time period using our Capitalization Rate (Cap Rate) calculator.
What Is Cap Rate?
The capitalization rate, often referred to as simply “cap rate”, is used in apartment property financing to determine the rate of return or net gain or loss of profit on an investment over a specified time period that is expected to be generated on an apartment property. Cap Rate is calculated by dividing the net operating income of a property by its market value and is expressed as a percentage. Cap rate is often utilized by appraisers to determine the value of a commercial property and is also the key metric behind the income capitalization approach to property valuation. It is used more often by investors trying to determine the potential return on their investment in the real estate market.
How Do You Calculate Cap Rate?
To understand how to calculate cap rate, imagine a property with a Net Operating Income of $500,000 at a market value of $5,000,000. This property would have a capitalization rate of 10%.
Cap Rate Calculator
Cap Rate Formula:
Capitalization Rate = Net Operating Income / Current Market Value!
In this particular example, $500,000 (NOI) divided by $5,000,000 = 10% (cap rate).
In a lesser used capitalization rate formula, the figure is determined based on the original capital cost or acquisition cost of the target property. the formula looks like this:
Capitalization Rate = Net Operating Income / Purchase Price
However, this version is not as popular since it gives unrealistic results for properties that were purchased several years prior at lower prices. Additionally, this method can't be applied to an inherited property since the purchase price is zero, thus rendering the division impossible.
Another valid consideration is that since property prices fluctuate widely, the original formula using the current market price results in a more accurate representation when compared to the second formula, which uses the fixed value original purchase price.
Understanding and Utilizing Cap Rate in Real Estate
Cap rate is the most widely utilized calculation through which investors and lenders can assess the profitability and return potential on an apartment property investment. Put simply, cap rate represents the yield of a property over the duration of a year. Cap rate also indicates the length of time it will take an investor to recover a staked amount in a property. In other words, a property having a cap rate of 10% would be expected to take around 10 years for an investor to recover the investment amount. Additionally, you can use the relationship between a property’s NOI and cap rate to determine the property value if you know what cap rates similar properties (commercial properties of similar vintage and asset class) are trading for in that sub-market.
While capitalization rate can be useful for lightly comparing the relative value of similar properties on the market, it can’t be trusted as the sole indicator of an investment property’s strength because it does not take some key factors such as leverage into account. Leverage, or, the time value of money and future cash flows from property improvements, is a major metric for investment consideration and financing.
Since capitalization rates are based on projected estimates of future income, it goes without saying that they are subject to high variance. It then becomes imperative for the investor to understand what constitutes a good cap rate for an investment in any given situation. In regards to apartment loan programs, there are no clear ranges for a good or bad cap rate, and the ranges that investors do come to find are typically largely dependent on the context of the property and the market it resides in.
Cap Rate Calculator
How lenders use cap rates on a refinance
On a refinance, the cap rate is how your building's NOI becomes an appraised value, and the appraised value is what the lender's LTV limit is applied to. A small change in the cap rate the appraiser picks moves your maximum loan by hundreds of thousands of dollars.
The chain runs like this:
- The appraiser sets a cap rate from recent sales of comparable apartment buildings in your submarket, adjusted for age, condition and size. You do not choose it, and neither does the lender.
- Value = NOI / cap rate. The appraiser uses its own NOI estimate, which may differ from your operating statement.
- LTV limit = value x maximum LTV. Fannie Mae Small Mortgage Loans and Freddie Mac Conventional Small both allow up to 80% LTV; many lenders hold cash-out refinances to a lower figure.
- The loan is the lower of the LTV-sized loan and the DSCR-sized loan.
Say a building has $560,000 of NOI. At a 6.0% cap rate it appraises at about $9,333,000, and 75% of that is $7,000,000. If the appraiser instead uses 6.5%, value drops to about $8,615,000 and the 75% loan to about $6,462,000. Half a point of cap rate cost about $538,000 of loan proceeds.
Why the cap rate is not always what limits you
Run the DSCR test on the same building before you argue about the appraisal. At a hypothetical 6.25% rate, 30-year amortization and a 1.25x minimum, $560,000 of NOI supports only about $6,064,000 of loan, less than either LTV figure above. In that case the cap rate is not your constraint: the rate is. When loan rates sit near or above cap rates, the DSCR test usually binds first, and a better appraisal adds nothing to proceeds.
That is the most useful thing to know before a refinance: which limit binds. If LTV binds, a higher appraisal or a lender with a higher LTV limit helps. If DSCR binds, you need more NOI, a lower rate, longer amortization or a program with a lower coverage minimum. The refinance worksheet runs LTV, DSCR and debt yield side by side for each agency program and shows which one sets the loan. To see what you would net after payoff and costs, use the cash-out refinance calculator, and to compare against the full refinance math, the apartment refinance calculator.
Cap rate questions on refinancing
Who decides the cap rate used to value my building for a refinance?
The appraiser engaged for the lender. The appraiser derives the cap rate from recent sales of comparable apartment buildings in your area and adjusts for differences in age, condition, location and size. The lender then reviews the appraisal. You can supply sales you think are comparable, but you cannot set the cap rate, and neither can your loan officer.
How does the cap rate affect how much I can refinance?
The appraised value is NOI divided by the cap rate, and the maximum loan under the LTV test is that value times the lender's LTV limit. A higher cap rate means a lower value and a smaller LTV-sized loan. For example, $560,000 of NOI at a 6.0% cap supports a 75% loan of $7,000,000, but at 6.5% only about $6,462,000.
Does a better appraisal always increase my loan?
No. The loan is the lower of the LTV-sized amount and the DSCR-sized amount. When interest rates are high relative to cap rates, the DSCR test often produces the smaller loan, so a higher appraised value does not change proceeds. Check which limit binds on your numbers before spending effort contesting an appraisal.
Is the cap rate the same as my return on the building?
Not quite. The cap rate is NOI divided by value with no debt, so it measures the property's unlevered income yield at that value. Your return depends on your purchase price or equity, your loan terms and how NOI and value change over time. For returns, use cash-on-cash return or IRR; for financing, use the cap rate the appraiser applies.