In the real estate industry, there are a lot of specific words and formulas you need to learn. A common real estate term is capitalization rate or cap rate. So, what is cap rate in real estate? It is a formula that real estate investors use to determine the value and potential return on an investment property. While a property’s cap rate isn’t the only way to evaluate its potential, the rate amount is considered one of the most important metrics for investors to know.
Along with knowing the cap rate, it’s equally important to ensure that all the numbers within the formula are as accurate as possible. To help you better understand cap rate, we will show you how and when to use it.
Cap Rate Definition
A capitalization rate, or cap rate, is the annual rate of return that is expected to be generated on a real estate investment property.
Cap rate is the most common way to assess profitability and return potential on a real estate investment. This metric helps buyers determine their expected return on investment (ROI) before factoring in mortgage financing. The cap rate shows the property’s un-leveraged rate of return.
When to Use Cap Rate
A cap rate should be used to evaluate a buy-and-hold investment property before purchasing. It can also be used if you own an investment property and plan to sell it. Before putting it on the market, you should determine your property’s cap rate.
If you have already purchased an investment property and have not determined your cap rate, now is the time to do so.
Cap rate can be used for the following types of real estate:
- Single-family investment properties
- Condo and townhome rental properties
- Commercial real estate
- Multifamily rental properties
- Apartment buildings
- Landlords who wish to evaluate a property they own
When Not to Use Cap Rate
Sometimes, using a cap rate doesn’t make sense when looking at investment properties. Generally, a cap rate should not be used for the following:
- Fix and Flip: Investors using this strategy don’t care about potential rental income because they will sell the property instead of renting it out.
- Purchasing Land: Because the net operating income (NOI) on vacant land cannot be determined, cap rates are useless.
- Purchasing Vacant Property: Just like buying land, the cap rate is dependent on NOI, so it will be difficult to come up with an accurate number for projected rental income. It can also be hard to accurately estimate operating expenses on a vacant property.
- Purchasing a Vacation Rental Property: Cap rates on vacation homes do not accurately predict the value of a property because it is not rented out year-round.
- Short-Term Rental Property: Because a cap rate is calculated annually, short-term rentals skew the cap rate, similar to a vacation rental.
How to Calculate a Cap Rate
Cap rate is calculated by the NOI divided by the purchase price or value of a property.
Cap Rate = NOI / Purchase Price
An accurate purchase price can be determined by looking at recent sale prices of comparable properties in the area.
How to Calculate NOI
Net Operating Income is income generated annually from an investment property minus the expenses associated.
Gross Rental Income – Vacancy, Property Taxes, Property Insurance, Maintenance/Repairs, Utilities, Other Expenses = NOI
After the NOI and purchase price have been calculated, the cap rate can be applied to the property you’re considering buying to show its current market value based on income. The cap rate will also help the buyer decide if the asking price on the property is reasonable.
Why is Cap Rate Important?
Determining the cap rate on a potential investment property is extremely important because it provides an accurate assessment of the annual income potential. It’s an especially great tool for comparing similar properties.
Using Cap Rate to Compare Properties
If you’re looking at two similar properties, but one costs more, it may be because it generates more income or has lower expenses. The cap rate will explain why one property may be more profitable than a similar property.
Cap Rate Focuses on the Property, Not Financing
The cap rate formula does not include mortgage expenses. This is another reason it’s so useful: It excludes the debt and focuses on the property alone. The cap rate assumes the property is bought with cash.
By assuming a property is being purchased with cash, cap rates allow investors to focus on the property’s financials rather than the debt.
Using Cap Rate to Measure Risk
Using the cap rate allows you to compare the risk of one property or market to another. In theory, a higher cap rate means a higher-risk investment, while a lower cap rate means an investment is less risky.
What is a Good Cap Rate?
Determining a good cap rate can be difficult because it depends on demand, available inventory in the area, and the property type. However, a cap rate between 4 percent and 10 percent is fairly typical and considered a good cap rate.
A good or bad cap rate can be very subjective to various investors, depending on their individual investing strategies.
For instance, a cap rate around 5 percent may be the average in higher-demand areas, such as large metropolitan, high-cost area. On the other hand, an up-and-coming neighborhood with lower demand on the outskirts of town may produce a cap rate upwards of 10 percent.
Buyers usually want a high cap rate, or the purchase price is low compared to the NOI. However, as stated above, a higher cap rate usually means higher risk, and a lower cap rate means lower risk.
Real estate investors must see which factors were used to calculate the cap rate to fully understand the financial outlook of the potential investment.
When deciding on a good cap rate, make sure you compare the same property types in similar areas. It won’t make sense to compare cap rates between a single-family home and a commercial building.
Factors that Affect Cap Rate
Cap rates vary among different types of residential and commercial real estate. The following factors can affect a cap rate:
- Location: Typically, a property in a good location or neighborhood has a higher market value, which equals higher rents.
- Asset Class: The type of property such as apartment buildings, single-family, multi-family, or commercial properties. Generally, commercial properties have higher cap rates than residential properties.
- Available Inventory: The lower the inventory, the higher the demand. The number of properties in the area that are available to buy impacts cap rates.
- Interest Rates: Rising interest rates can lead to lower cap rates.
Limitations of Cap Rate
If a property is new or less than five years old, the use of a cap rate is limited because it can be difficult to calculate an accurate net operating income figure for revenues and operating expenses.
This is why there are other important calculations investors should use when deciding on different real estate investments.
Cap Rate vs. ROI
Another great way for investors to evaluate an investment property is to calculate the ROI, or return on investment. ROI can be determined by calculating the annual return and dividing that by the total cash investment. Then, subtract expenses from total rental income to calculate the annual return.
Unlike cap rate, ROI may include financed transactions. Determining ROI on cash transactions is pretty straightforward, but calculating ROI on financed transactions can be more complicated.
Example of Calculating ROI with Cash Purchase
For example, let’s assume you are looking at an investment property for $100,000 and put 20 percent of the purchase price down, or $20,000. Closing costs were $2,000, and you spent $5,000 on remodeling. Your total out-of-pocket expenses were $27,000 ($20,000 + $2,000 + $5,000).
Example of Calculating ROI with Financing
Now, let’s calculate the costs with a mortgage. Assuming your loan is a 30-year, with a fixed interest rate of 4 percent, $80,000 (loan amount) + 4% interest = $381.93 per month on a mortgage payment. Add extra costs of $150 for expenses like taxes, insurance, utilities, etc., making your total monthly payment $531.93. Monthly rental income of $1,000 and $12,000 annually. Your monthly cash flow or ROI would be $468.07 and $5,616.84 annually.
Final Thoughts
Now that we have answered the question, what is cap rate in real estate, you’ll be able to more accurately determine the value of a property compared to its expenses. Ultimately, having the tools to decide between a higher or lower cap rate and which works best for your investing strategy will be an important factor in successfully earning the ROI you want to get.
