What Is Cap Rate And How Do You Calculate It?
Property investors around the world use property cap rate – otherwise known as capitalization rate – to gauge the risk associated with acquiring new residential or commercial real estate properties. The cap rate is also used as a method to assess the type of return they can expect on their investments.
Let’s take a close-up look at how to calculate cap rate for real estate investments – and see how this formula can serve as a helpful tool whenever you’re considering new properties to add to your portfolio.
What Is Cap Rate In Real Estate?
Cap rate is a method of assessing the financials on a property. It effectively describes the percentage of the property’s value that you may be able to collect in income – typically in the form of rent – each year after factoring in expenses.
Put simply, cap rate describes the general rate of return that you’re seeking on a real estate investment given the total amount of income that the property is likely to funnel your way. As you consider buying a real estate investment property, cap rate is an important figure to keep in mind because it helps you get a sense of potential return on investment (ROI). A property’s capitalization rate is generally expressed in the form of a percentage.
What Are Capitalization Rates Used For?
Cap rate can also serve as a helpful comparison tool when considering the relative value and merits of various potential real estate investments. Capitalization rate helps you get a better sense of the rate of return you stand to earn on an acquisition, based on the net income of the property.
Cap rate, however, isn’t the only way to determine an investment’s strength. A variety of factors – including leverage and time value of money – may influence a property’s attractiveness to a potential investor.
Think of cap rate – which is calculated by dividing a property’s net operating income (NOI) by its market value (purchase price) – as a quick-hit estimate of sorts. It can help you get a sense of how much you stand to make on real estate investments, but it shouldn’t be the sole influencer of any purchase decision.
Along with providing investors with a snapshot of potential returns, cap rate can help you compare the relative value of what may seem to be similar real estate investment opportunities.
How Does A Cap Rate Work?
Cap rate doesn’t account for leverage, and it assumes a property was bought with cash (not via loan). It likewise assesses potential profitability by examining a real estate holding’s yield over a 1-year time span.
However, despite the limitations of cap rate, it’s still one of the most popular ways to evaluate real estate investments because it reveals the likelihood of a property to deliver cash flows and a healthy return on any sums that an investor invests.
In essence, the cap rate formula offers a simple and practical way to analyze various real estate markets and rental properties – and it serves as a useful tool if you’re considering investing. Equipped with cap rate, you can make a more effective comparison of real estate investment opportunities and make any purchases with greater confidence.
Perhaps best of all, cap rate uses one of the simplest calculation formulas in the world of real estate finance, as it simply summarizes the ratio of a rental property’s NOI to its purchase price.
Put simply: The higher the cap rate of a property, the higher your potential returns; the lower the cap rate, the less you stand to earn. But as with gambling, the riskier deals tend to yield higher returns. So, while properties with lower cap rates tend to generate less revenue (or revenue potential), they’re often considered safer investments.
Again, though – as a simplistic tool, cap rate should largely be considered a shorthand approach for computing the value of investing in specific properties. Due to the simplicity of the cap rate formula, investors typically use it to get a quick-hit sense of whether a property is worth a closer look.
How To Calculate Cap Rate
Capitalization rate is calculated by dividing the NOI of the property (or the annual income generated after deducting all expenses for managing and maintaining it) by its current market value (the present-day value of the property at current market rates).
Cap rate can also be computed by dividing the net operating income of the property by its acquisition cost (or purchase price).
To calculate the cap rate of an investment property, you can use the following formula:
Capitalization Rate = Net Operating Income / Current Market Value of Property
So, you would begin by figuring out the NOI:
- Add up all revenue streams. If you’re looking at a multifamily rental property, you would want to add up each tenant’s annual rent to get the property’s gross income.
- Add up all the property’s expenses. Figure out the annual cost of property taxes, insurance, utilities, repairs, maintenance, and administrative and management fees, and add these costs.
- Factor in potential vacancies. While you should look at your market to find the local vacancy rates, you can also assume a vacancy average of 10%. So, take your annual rental income and subtract it by 10% (or whatever the market vacancy rate is in your area).
- Calculate the NOI of the property. Take the result and subtract the rest of the property’s expenses, which will give you the property’s NOI. Once you have the NOI:
- Calculate the cap rate. Divide the NOI by the property’s market value. Remember, the current market value is the property’s purchase price.
Perform this calculation, and you’ll get a sense of what type of returns a property may generate, how long it will take to recover your investment, and the relative risk associated with investing in a particular piece of real estate.
As noted, the cap rate formula doesn’t include down payments, mortgage expenses, interest rates and other payments.
What Is A Good Cap Rate?
Ironically, as helpful of a tool as cap rate is for making basic real estate calculations, it’s hard to say what constitutes a good transaction without accounting for the individual context and market in which a property operates.
Regardless, different cap rates for different investment properties – or the same property when spread across different time horizons – tend to offer a useful snapshot of various levels of investment risk.
Naturally, the higher the net operating income that a property generates and the lower its valuation, the higher the cap rate value tends to be. Cap rate also helps reveal how much time it will take to recover any amount you invest in real estate opportunities. For example, a property with a cap rate of around 5% will take about 20 years to recover your investment.
A higher cap rate generally means that an investment is riskier, and a lower cap rate means it’s less risky – at least in theory. That’s because properties with higher cap rates tend to have lower valuations and therefore present more risk. On the flip side, properties with higher valuations (and potential hiccups attached) often present lower cap rates and less risk.
As a general rule, based on surveys of major markets across the U.S., a property’s cap rate is often considered “good” if it’s 4 – 10%. But take these numbers with a grain of salt because actual figures will depend on individual property type, location, market and other variables.
Similarly, individual investors may have different perspectives on what constitutes a “good” cap rate. Safe and stable opportunities attract many real estate buyers, but some investors may be happy taking on bigger risks because of the potential for bigger returns.
Cap Rate Example
Let’s say you’re thinking of purchasing a 20-unit apartment building at $2 million. It’s in good condition, well-managed and situated in a good, stable and fast-growing location with solid prospects for economic growth.
For purposes of calculation, imagine now that you’re collecting $20,000 in total monthly rent ($1,000/unit). Monthly operating expenses are $5,000, which – when subtracted – leave you with $15,000 of net operating income per month, or $180,000 per year ($15,000 x 12 months). Your cap rate would be 9% ($180,000 / $2 million).
This seems like an attractive deal, but you’ll never know until you compare it with another property – say, one up the block with fewer units but situated on a popular public thoroughfare and generating more income per unit.
How Accurate Is The Cap Rate Formula?
Looks aren’t everything. While the cap rate formula can provide a snapshot of whether an investment is worth purchasing, it won’t provide you with 100% context surrounding potential acquisitions. Property investment is inherently risky, after all.
For example: If several tenants moved out, you may find that your net operating income has shrunk and potential cap rate has dwindled – meaning you might actually be able to make more money with less risk by investing in other opportunities.
What Other Factors Can Affect Cap Rate?
The market value of your property may shrink while costs remain the same over a period of years, or its market value might hold steady. However, maintenance- and property tax-related expenses may unexpectedly balloon, also influencing cap rate.
As you go about weighing cap rate calculations, remember that differing levels of property income and expense, and shifting market valuations, can impact your capitalization rate (and the risk associated with an investment) over time.
Cap rate can be drastically affected by the age, location and type of property, as well as factors like market solvency, tenants’ financial well-being and regional economics. Don’t assume cap rate is the only variable to consider when weighing prospective investments.
The Bottom Line: Cap Rates Can Be Useful For Calculating A Real Estate Investment
Cap rates offer a handy method to quickly determine the relative level of risk and return associated with making a real estate investment, at least off the cuff. Capitalization rates also provide a sense of how well investment opportunities stack up against one another.
Are you ready to dive into the world of real estate investing? Start by evaluating real estate comps now.