The cap rate of property is a major deciding factor for investors because it allows them to compare the ROI of one property with another, as well as with other investment options such as certificate of deposits and stock funds.
Cap rates are usually calculated in the following manner:
Cap Rate = Annual net Income/Cost
The annual net income is derived by subtracting the projected income of the property (usually made by renting it out and varies according to the type of property, its location and condition) from incurred expenses that are due after purchasing it. These include property taxes, insurance, maintenance, monthly mortgage rates, etc.
The cost of property includes the cost of property as the taxes that are required to be paid at the time of purchase, including the registration and transfer fees.
Sometimes, the annual appreciation rates of the property is added to the cap rate to get a cleared idea of the projected profit on the income derived from the property.
For example, if the value of a property is expected to increase by 7% and its cap rate is 10%, then the overall cap rate is 17 % (10+7).If property’s value is expected to decrease by three percent, and then the cap rate is 7% (10-3)
In most instances, a residential property usually has a lower cap rate than a commercial one.