Wondering how to calculate the capitalization rate (cap rate) for real estate holdings? Join the club: Thousands of real estate investors worldwide use a property’s cap rate as a means through which to gauge the risk associated with acquiring a new holding … and as a method to assess what type of return they can expect on their investments.
Here, we take a closer look at how to calculate capitalization rate for real estate investments – a surprisingly simple formula that can serve as a helpful tool whenever you’re considering which new properties to add to your portfolio.
What Is Cap Rate?
Cap rate is a method of assessing the financials on any given piece of property. It effectively describes the percentage of the overall value of a property that you might hope 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 might hope to bring in on a real estate investment given the total amount of income that the property is likely to funnel your way. As you go about considering buying a real estate investment property, it’s an important figure to keep in mind as 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.
Note that cap rate can also serve as a helpful comparison tool when considering the relative value and merits of various potential real estate investments. That’s because it helps you get a better sense of the prospective rate of return that you stand to earn on an acquisition based on the net income of the property.
That said, it should not be used as the only way to determine an investment’s strength. After all, a variety of factors may influence how attractive a property may be to a potential investor such as leverage, time value of money, and more.
Think of cap rate – which is calculated by dividing a property’s net operating income 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 in returns on various real estate investments, however it should not be used as the sole arbiter of any purchase decision.
Where cap rate often comes in most handy, besides providing investors with a snapshot of potential returns, is as a way to compare the relative value of what may seem (at least on paper) to be similar real estate investment opportunities.
How Does A Cap Rate Work?
Cap rate does not account for leverage and 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 these limitations, it’s still one of the most popular means through which real estate investments are evaluated in terms of gauging their potential to deliver profitability and a healthy return on any sums that an investor chooses to outlay.
In essence, the cap rate formula offers a simple and practical way through which to analyze various real estate markets and rental properties – and serves as a useful tool if you’re considering investing. Equipped with it, you can make a more effective comparison of various real estate investment opportunities and make any purchases with greater confidence. Best of all, cap rate is one of the simplest formulas that you can calculate in the world of real estate finance, as it simply summarizes the ratio of a rental property’s net operating income to its purchase price.
Put simply: The higher the cap rate of a property is, the higher the potential returns you stand to make, and the lower that it is, the less you stand to earn. But as with gambling, it’s the riskier deals that tend to lead to higher returns. So although properties with lower cap rates tend to generate less revenue (or revenue potential), they’re often considered to be 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 its simplicity, investors typically use the cap rate formula to get a quick-hit sense of whether a property is worth a closer look.
What Is A Good Cap Rate?
Ironically, as helpful a tool as cap rate is for making some basic real estate calculations, it’s hard to say what constitutes a good one without accounting for the individual context and market within which any given property operates. Regardless, differing cap rates among various investment properties or on the same property when spread out across differing time horizons tend to offer a useful snapshot of various levels of potential investment risk.
Naturally, the higher net operating income that a property generates and the lower its valuation, the higher the cap rate value tends to be. Cap rate also provides a measure of indication of how much time it will take to recover any given amounts that you elect to invest in real estate opportunities. By way of example, a property with a cap rate that sits around 5% will take about 20 years to recover your investment upon.
Worth noting, though: As alluded above, and although it may seem counterintuitive at first blush, a higher cap rate generally means that an investment is more risky and a lower cap rate means that it is 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, those 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 USA, a property’s cap rate is often considered “good” if it sits between 4% – 10%. But take these numbers with a grain of salt – 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 are certainly an attractive proposition to many real estate buyers, after all. But don’t forget that some investors may be all too happy to take on bigger risks with an eye towards bigger potential returns as well.
How To Calculate Cap Rate
Capitalization rate is calculated by dividing the net operating income of the property (annual income generated after deducting all expenses for managing and maintaining it) by its current market value (present-day value of the property at current market rates).
Alternately, it can be computed by dividing the net operating income of the property by its acquisition cost (aka 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 to get the property’s gross income. If you’re looking at a multifamily rental property, you would want to add up each tenant’s annual rent.
- Add up all the property’s expenses: Figure out the annual cost of property taxes, insurance, utilities, repairs, maintenance, administrative and management fees and add these costs.
- Factor in potential vacancies: While you should look at your market to see what local vacancy rates are, 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).
- 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 current 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 any given piece of real estate.
As noted, the cap rate formula does not take into account down payments, mortgage expenses, interest rates and other payments.
Cap Rate Formula
Say you’re considering purchasing a 20-unit apartment building at the price of $2,000,000. 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 ($1000/unit). Monthly operating expenses are $5000, 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 / $2,000,000).
It certainly seems like an attractive deal: However, you’ll never know until you compare it with another property – say, one up the block with fewer units, yet is situated on a popular public thoroughfare and generates more income per unit. Then again, looks aren’t everything: As a friendly reminder, while the cap rate formula can provide a snapshot of whether an investment is worth purchasing, it won’t provide you with 100% complete context surrounding potential acquisitions. Property investment is inherently risky, after all.
For example: If a number of tenants were to elect to move out, you may find that your net operating income has shrunk, and potential cap rate has dwindled – meaning that you might actually be able to make more money with less risk by putting it into other investment vehicles.
Alternately, the market value of your property may shrink while costs remain the same over period of years, or its market value might hold steady, but maintenance- and property tax-related expenses may unexpectedly balloon – also impacting cap rate as well.
As you go about weighing cap rate calculations, remember: Differing levels of property income and expense, and shifting market valuations, can impact your capitalization rate (and the risk associated with any given investment) over time. Given how drastically that cap rate can be 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 it’s the only variable to take into consideration when weighing prospective investments as well.
The Bottom Line: Cap Rates Are Useful For Calculating A Real Estate Investment
Cap rates offer a handy method through which to quickly determine the relative level of risk and return that is associated with making any given real estate investment, at least off the cuff. They also provide a quick-hit way to get a sense of how well different investment opportunities stack up against one another.
A popular tool for comparing potential acquisitions, and various real estate markets, cap rates aren’t infallible, though. That’s because they don’t into account all possible risk factors or variables associated with purchasing a piece of property – variables and risk factors that can only become more pronounced over time to boot.
Interested in learning how to more effectively use cap rate formulas to help you make smarter investment decisions? You’ll be in good company; however, as thousands of investors worldwide already do so, at least to get a general sense of where it may be a good idea to place financial bets using their capital.
To begin putting cap rates to work for you immediately, a good place to begin would be to start looking at real estate comps now.