What Is A Cap Rate And How Is It Calculated?
Thinking of buying an apartment building as an investment property? Or maybe you're ready to make a smaller investment by purchasing a single-family home and renting it out?
In either case, you'll want to know how much money you can expect to earn from your investment property each year. You'll also want an idea of how risky your investment might be: How likely is it that your investment property won't generate enough income to cover its purchase and operating costs?
This is where a property's cap rate, also known as its capitalization rate, comes in. Investors calculate cap rates to gauge the risk and income potential of residential and commercial real estate properties.
But how do you calculate a property's cap rate and what does the resulting number tell you? Here's a look at how cap rates work and why they're one tool that can help you make a smart real estate investment.
What Is A Cap Rate?
Calculating a property's cap rate is one way to estimate the percentage of the real estate's value that you might be able to collect in income each year, typically in the form of the rent you can charge to tenants.
This is a more accurate way of estimating a property’s income potential. That’s because a property’s cap rate factors in the expenses of owning and maintaining the building.
When buying an investment property, you can't consider only the potential rent you can earn. You also need to look at the expenses that eat into a building’s monthly income. These may include the cost of hiring property managers and custodians, the mortgage payment, insurance and property taxes you’ll pay each year and the money you’ll spend maintaining the property. You’ll also want to factor in any dues if the property is a condo or in a homeowners association (HOA).
When you consider both your income potential and your expenses – a property's cap rate – you can better determine the return on investment that a real estate purchase might generate.
The higher a property’s cap rate, the higher your potential returns. The lower its cap rate, the longer it might take to get a return on your investment. But properties with higher cap rates can be riskier because there might be more work needed to maintain or update the property or it may be in a more undesirable area or one that has less marketability. While you might earn more from such assets, the odds of you losing money can be higher. Even if you don’t earn as much from a building with a lower cap rate, the odds are lower that you’ll lose money.
Whether you want a property with a high or low cap rate, then, depends largely on your tolerance for risk. If you’re aiming for the highest possible profits, seek out a property with a higher cap rate. If you want a safer investment, target one with a lower cap rate.
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When Are Cap Rates Used?
Investors can calculate the cap rates of properties to help them compare the value of potential real estate investments. If these investors know the cap rates of the properties they’re considering, they can better determine the rate of return they might earn on an acquisition. This might lead them to invest in a multifamily property in a desirable part of town instead of an office building that requires expensive upgrades.
A cap rate provides a quick estimate for investors on how profitable a real estate investment may be. But investors should never rely solely on cap rates when deciding which properties to purchase.
Instead, they should consider a host of factors, including the age of a property, its vacancy rate, the quality of existing tenants and the desirability of the neighborhood in which it sits.
How To Calculate Cap Rate
Calculating a property’s cap rate is a fairly simple process. Any property owner or investor should be able to apply this formula when evaluating the income potential of residential or commercial real estate.
You calculate a property’s cap rate by dividing its net operating income by its market value.
Here is the cap rate formula:
Capitalization rate = Net operating income/current market value (or sale price) of the property
1. Calculate The Net Operating Income (NOI)
Your first step in calculating a property’s cap rate is to determine its net operating income, which is the amount of income you can expect it to generate each year. Real estate investors use this figure to help determine how much profit they can earn from an apartment building, office building, single-family home or other property.
What factors make up a property’s net operating income?
Total revenue generated: In most cases, your investment property will generate income from the rent you charge your tenants. In a multifamily property, these rents will come from the renters living in your building. In an office, retail or industrial property, your rent will come from the tenants filling those spaces.
The property’s total expenses: Owning a building is expensive. Expenses include any mortgage payment associated with the property, annual property taxes, insurance, utilities, maintenance, repairs and management fees.
The total after subtracting expenses from revenue: Once you’ve calculated a building’s annual revenue and expenses, you’re close to determining its net operating income. Subtract the building’s expenses from its revenue to calculate net operating income.
For example, say you’re considering investing in a multifamily property with six rental units. You plan on charging a $1,200 rent for each unit. That comes out to a revenue of $7,200 a month or $86,400 a year.
Say, too, that the expenses involved in owning and maintaining this building come to $4,000 a month or $48,000 a year. If you subtract $48,000 in expenses from $86,400 in revenue, you get a net operating income for the year of $38,400. This is the amount of money an investor could reasonably expect to earn from owning the property.
2. Divide NOI By Market Value
Next, you’ll divide your property’s net operating income by its current market value. It’s easy to determine an investment property’s market value: It’s the sale price that you and the seller agree upon.
Say the six-unit multifamily property you want to buy is selling for $500,000. When you divide its net operating income of $38,400 by $500,000 you get 0.0768.
3. Convert Results Into A Percentage
Finally, convert the result of this calculation into a percentage. In this case, 0.0768 would come out to a cap rate of 7.68%. To convert your raw calculation to a percentage, move the decimal point over to the right by two spaces.
Cap Rate Example
Here’s another example of how to figure a property’s cap rate.
Say you’re considering a multifamily property that brings in $7,000 in revenue each month and the property is selling for $750,000.
- Net operating income: You determine that the multifamily property’s monthly expenses are $3,900. You can now calculate its net operating income. You’ll spend $46,800 in estimated expenses each year, or $3,900 in monthly expenses multiplied by 12. You’ll earn an estimated $84,000 in income, which you get by multiplying the property’s $7,000 in monthly revenue by 12. You then subtract the property’s $46,800 in expenses from the $84,000 in income it generates to get a net operating income of $37,200 each year.
- Market value: Your property’s current market value is the final sale price agreed upon by you and its seller. In this case, the market value is $750,000, its final sales price.
- Cap rate: Divide the multifamily building’s net operating income of $37,200 by its market value of $750,000 to get 0.0496. To convert that to a percentage, move the decimal point two spaces to the right, which gives you a cap rate of 4.96%
What Factors Affect Cap Rates?
The expected revenue that a property generates each year isn’t the only factor that impacts its cap rates. Other attributes of the property and its neighborhood also play a role.
Some of these factors include:
Properties located in desirable neighborhoods typically have a higher earnings potential. Owners can charge higher rents for properties in neighborhoods dotted with restaurants, shops and entertainment. Those located near public transportation such as subway or rail stops can often fetch higher monthly rents, too. On the negative side for investors, these properties also tend to come with higher sale prices.
On the flip side, locations that are less desirable or more inconvenient may have lower sale prices, but may also require you charge lower rent.
The ups and downs of the local real estate market can impact cap rates, too. Properties tend to earn higher rents, and monthly income, when the real estate market is strong, something that can boost their cap rates. At the same time, properties’ market values rise in stronger markets. You’ll pay more for a property when demand for real estate is higher. That higher asking price could lower a property’s cap rate.
Condition Of The Property
The condition or quality of a property is another important factor for cap rates. If a multifamily property is well-maintained and features desirable amenities, it’s more likely to attract strong demand from renters. Its owner can then charge higher rents, something that will boost the property’s net operating income and result in a higher cap rate. These buildings, though, tend to cost more, too. That can have the opposite effect, pulling a property’s cap rate down. Properties that are aging, lack amenities and need renovations, can often be bought at a lower price, which can push a cap rate up. However, owners usually charge lower rents for these properties, which can then send a cap rate down.
Is There a Good Cap Rate?
How do you know if a cap rate is good or bad? It largely depends on your goals as an investor.
A higher cap rate usually means that an investment is riskier, while a lower cap rate means it is safer. If you're looking for the opportunity to make a lot of money in less time, though, you might want a property with a higher cap rate. Yes, the risk that you'll lose money is higher, but so are the odds that you'll earn a higher profit.
If you want a safer place for your investment dollars, you might consider a lower cap rate to be the better choice when buying a house or other investment property. You might not make as much of a profit, but you also run a lower risk of losing money.
In general, though, a property's cap rate is often considered "good" if it ranges from 4% to 10%. Again, you'll need to consider other factors to determine whether a cap rate works for you, including your investment goals, the type of real estate you want to buy, its location and the performance of the local real estate market.
Cap Rate FAQs
Have questions about cap rates and what they mean to real estate investors? Here are some answers.
Is a higher cap rate better?
The higher the net operating income that a property earns and the lower its market value, the higher its cap rate tends to be. Investors consider properties with higher cap rates to be riskier ones. This doesn’t mean that a higher cap rate is better or worse than a lower one. You can earn a greater profit with a property with a higher cap rate. You also run a higher risk of losing money.
What happens when properties have a bad cap rate?
If a building’s cap rate doesn’t work for you, you might consider passing on it. But what one investor considers a bad cap rate, another might consider ideal. It depends on your risk tolerance: If you want a safer investment in which you might earn a smaller profit but also face lower odds of losing money, you might consider investing in a property with a low cap rate. Investors more interested in earning a higher profit might consider the low cap rate that you prefer to be a bad one for their needs.
What is the cap rate formula?
A property’s capitalization rate = Its net operating income/its current market value
Is the cap rate formula accurate?
The cap rate formula is one useful tool for determining the profit potential of a real estate investment, but this formula shouldn’t be the only measure you look at when evaluating a multifamily property, office or warehouse investment. You’ll also need to consider a building’s age, location and upkeep. Consider, too, how many vacancies it has and how strong the local real estate market is.
The Bottom Line: Cap Rates and Real Estate
Investing in real estate can be a smart way to generate extra income. But it also comes with risks. The cap rate formula can help you determine how much risk you’ll face when investing in a multifamily building or other property. But remember that a building’s cap rate is only one measure of its income potential. It’s a starting point, but you’ll need to consider other factors, too, before deciding to invest.
If you’re ready to finance the purchase of an investment property, you can apply for a mortgage with us today.
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