How to Calculate a Capitalization Rate (Cap Rate)

When evaluating and comparing income properties, you
deal with cap rates. The cap rate is basically the return you will receive on your investment after expenses, but before debt service.

Example: If you purchase an apartment building for $1,000,000 and you receive $100,000 annually, after expenses, your cap rate would be 10% ($100,000 / $1,000,000).

The seller will want as low of cap rate as possible because the lower the cap rate, the higher the price. Conversely, the buyer wants as high of a cap rate as possible which will mean a lower price.

Think of it this way, if you are an investor and have $1,000,000 in cash, you would rather put it in an investment yielding 10% rather than 8%. But if you are a lender you would only pay 8% rather than 10%.

Most people will finance a large portion of their investment property. Banks usually want you to have 30% - 40% down, at least 20% of which must be in cash while the balance may be seller carryback.

How does this leverage affect your cap rate? Essentially, if the financing rate is lower than your cap rate, your return on investment increases. Conversely, if it is higher than your cap rate, your return on investment will decrease.