How to calculate the Cap Rate

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The Cap Rate is a quick way to check the financial outlook of a multifamily investment property. So how do you calculate the cap rate on an investment property? The basic calculation is pretty simple:

Cap Rate = Net Income / Property Value

Cap Rate Example
Let's do an example of calculating the Cap Rate. You’ll need these numbers:

1. Property Value. Not just the asking price, but what the property is actually worth. Your Realtor can help you determine this number by pulling comps for similar multifamily properties that have sold in the area. For our example let’s say that you’ve found a duplex that is worth $300,000.
2. Gross Income. This is the gross rent that the owner would receive. For our example we’re going to say that the property is rented with long-term tenants paying $1000/month per side. So the gross income for our example property is $24,000/year ($1000 x 2 x 12).
3. Net Income. You’ll need to find out ALL the expenses required to maintain the property EXCEPT for mortgage debt. A word of caution here: Most new investors are in such a rush to buy a property that they may overlook some expenses, or may estimate these on the low side. You want to take a breath here and be sure you’re working with REAL numbers, and that you’ve found all the expenses (be sure to check for HOA fees!). An unexpected or underestimated expense can wreck your ROI.
   
   

Calculating Net Income
The Net Income is Gross Income minus Expenses like insurance, taxes, maintenance and management fees (remember not to include debt payments).
To find the Net Income you’ll need to do some investigating and make sure you know exactly what ALL the expenses for the property are. One unexpected expense can wreck your ROI, and you don’t want to find that expense after closing.

Some common expenses to look for:

• Utilities: Be sure you know which utilities the owner pays and which the tenants pay. Ask for 12 months of history on any utility bills paid by the owner so you can see the annual cost.
• Lawn Maintenance: Who maintains the lawn? If it’s the tenant what are the repercussions if they don’t maintain it and the city or HOA issues a citation?
• Insurance: The seller might have discounts or other relationships with their insurance carrier, so be sure you get an accurate quote from your insurance company well before closing.
• Taxes: What are the property taxes for the property? What will they be after you purchase it and the city and county raise the appraised value to the amount you paid for the property?
• HOA Dues: Not usually applicable to multifamily but double check to be sure
• City licenses and fees: Many cities now require rental permits with an annual fee per unit.
  
  

Calculating the Cap Rate
To keep our example simple, let’s say we’ve discovered the following expenses related to the property: Annual property taxes are $4500; The annual insurance premium is $1200; and the owner pays water and trash which together are $2400 per year.

So our total expenses (not including debt servicing) come to $8100 per year.
The Net Income is then $15,900 ($24,000 gross income – $8,100 expenses)

Remember: Cap Rate = Net Income / Property Value

Therefore the Cap Rate on this $300,000 property is 5.3%
($15,900 net income / $300,000 property value)

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