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What is Cap Rate in Real Estate?
Approximate Reading Time: 15 Minutes
Summary: In this article, you will learn what is cap rate in real estate. Topics include, when to use capitalization rate, how to calculate cap rates, what is considered a good cap rate on investment properties, and why determining cap rates is important for real estate investors.
Capitalization rate is one of the more common ways for real estate investors to determine the value and potential return on an investment property. While determining a cap rate isn’t the only way to evaluate an investment property, it is considered one of the most important metrics for investors to know.
Not only is it important for investors to determine a cap rate, it’s equally important to make sure all the numbers within the cap rate formula are as accurate as possible. In this article, we will share how to accurately determine a property’s cap rate and help investors decide to move forward with an investment or not.
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, prior to 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, prior to 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
There may be times when 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 are going to sell the property instead of renting it out.
- Purchasing Land: Because it’s impossible to determine the NOI on a vacant piece of land, cap rates are essentially useless.
- Purchasing Vacant Property: Just like buying land, 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 a vacation home do not accurately predict the value of a property because it’s 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 Net Operating Income or 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 NOI and purchase price have been calculated, the cap rate can then 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 how much income may be generated annually. It’s an especially great tool to compare similar properties.
Using Cap Rate to Compare Properties
If you’re looking at two properties that are alike, but one costs more, it may be because it is generating more income or has lower expenses. The cap rate will break down 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 because it excludes the debt and focuses on the property alone. Cap rate assumes the property is bought with cash.
By assuming a property is being purchased with cash, cap rate allows investors to focus on the property’s financials and not the debt.
Using Cap Rate to Measure Risk
Using 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. A lower cap rate means an investment is less risky.
What is a Good Cap Rate?
Determining what is a good cap rate can be difficult because it depends on demand, available inventory in the area you’re looking and the property type. However, generally speaking, a cap rate between 4 percent and 10 percent is fairly typical and considered to be 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 areas. 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. But, as stated above, a higher cap rate usually means higher risk and a lower cap rate usually means lower risk.
It will be extremely important for real estate investors to see which factors were used to calculate the cap rate to fully understand the financial outlook of the potential investment.
When deciding a good cap rate, make sure you are comparing 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 means a higher market value, equaling 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. How many properties in the area are available to buy impacts cap rates.
- Interest Rates: Rising interest rates can lead to lower cap rates.
Limitations of Cap Rate
Where the use of a cap rate has limitations is if a property is new or less than five years old. Because the net operating income is part of the cap rate formula, it can be difficult to come up with an accurate figure for revenues and operating expenses on newer properties.
This is why there are other important calculations investors should use when deciding on a 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 annual return and dividing that by your total cash investment. Figure out your annual return by then subtracting expenses from total rental income.
Unlike cap rate, ROI may include financed transactions. Determining ROI on cash transactions is pretty straightforward. 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 for remodeling. 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.
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 investment strategy, will be an important factor to successfully earning a return you’re hoping for.
If you would like to learn more real estate investment terms, check out my recent article here.
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