Calculating Your Cap Rate and Creating Positive Leverage

The capitalization rate, or cap rate for short, is the rate of return on an investment property based on the amount of income it’s expected to generate in the present year. By calculating the cap rate of a property, you can see the potential rate of return on an investment. Compare the cap rates of multiple properties to see which one is the wisest investment.

Calculating the cap rate

The equation to manually calculate a cap rate is fairly simple. All you have to do is calculate the investment property’s net operating income (NOI) by subtracting the total operating expenses from the total operating revenue. Then, you divide the result by the value of the property.

total operating revenue – total operating expenses = Net Operating Income (NOI)

Net Operating Income (NOI) / value of property= Cap Rate

Let’s go through this with an example. Suppose that you’ve just bought office space for your growing business valued at $800,000. In the coming business year, you expect to earn $300,000, but it costs you $200,000 to maintain your office space and run your business.

Step 1: Calculate the NOI

When you subtract your total operating expenses from your total operating revenue, you find that your NOI is $100,000.

$300,000 – $200,000 = $100,000

Step 2: Calculate the Cap Rate

To calculate the cap rate, you divide your previously calculated NOI by the value of the investment property to find that the cap rate is 0.125, or 12.5%.

$100,000$800,000= 0.125

Creating positive leverage

Don’t rely on the cap rate alone when evaluating an investment. It is important to consider all aspects of an investment property, such as the loan amount and the loan interest rate, before you decide to take the plunge.

Having positive leverage means that you have enough return on your investment property to pay back the loan. To create positive leverage, buy property with a cap rate above the interest rate, ideally with a large margin of difference. This will ensure you have a high return on your equity.

For more information on cap rates and creating positive leverage, check out the following links:

On what cap rates are

Oh how to calculate a cap rate

On how to know what a good cap rate is

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