Real estate investors calculate a “cap rate” to estimate the rate of return on a property. The cap rate is a simple calculation that determines whether or not a real estate investment will be worthwhile.
The cap rate formula is the following:
Cap Rate = Annual Net Operating Income / Property FMV
A rental property’s net operating income is the gross rent minus all operating-related expenses. Operating expenses include:
- Property taxes
- Regular repairs and maintenance
- Insurance
- Legal and professional fees
- Advertising
- Cleaning fees
- Utilities
What items are generally excluded from the NOI calculation?
- Interest Expense. NOI excludes interest expense, principal payments, and other debt service costs because these vary widely between investors.
- Depreciation Expense. Depreciation is a non-cash expense that doesn’t impact the property’s net cash flow. Therefore, investors exclude it from the NOI calculation; however, it is very important for federal tax purposes.
- Capital Expenditures. The cap rate formula analyzes the property’s regular operating income and expenses, excluding major capital expenditures that do not occur annually.