Capitalization rate (or “cap rate”) is a measure of the ratio between the cash flow produced by the rental property that you have purchased as a real estate investments and either its original price paid or its current market value.

  • annual cash flow / cost (or value) = Capitalization Rate

Cash flow is the amount left over after all your fixed costs and variable costs are removed from your gross rental income for the year.

That is the general way to compute the cap rate for your rental property.  The average nationally, according to Wikipidiea for rental properties is running about 5%

Example:

Let’s say you paid 65,000 for a property that produces a $900 a month rent.

Closing costs and fees run say $3500 for a total in price of $69,000.

Annual cash flow = 10,800 a year income less your expenses, assuming no vacancies.

For this example, 100% down at 6.5% yield PI at 436 a month or 5232 for the whole year, leaving 5568.

Taxes and insurance at $170 a month (2040 for the year) leaves 3528, annual cash flow.

Thus annual cash flow / 69000 = Cap rate of 5%.

Variables

There are all sorts of other variables to consider such as future repair monies, vacancy credits, and simple overhead such as accounting and things like depreciation expenses.  How much fine tuning you want to do is up to you.  Some investors will include the vacancy rate, others will not.  It’s your choice.  It’ll still impact your rate.

There are also other formulas out there as well, but this is one commonly accepted version.