Cap Rate and What Every Investor Needs to Know PLUS Calculator

Cap rate is a priority in the real estate industry. Despite being a popular and central concept, it is sometimes misconstrued and misused but it is easy to understand.

For many investors, evaluating the capitalization rate of a property provides insight on the probable gain over a year. In this post, you’ll learn what the capitalization rate is and how to calculate and maximize it in real estate investing.

What is the Cap Rate?

Cap rate (Capitalization rate in full) deals with the rate of return on an investment. Basically, it is the ratio of Net Operating Income to a property’s asset value. The rate is usually calculated as a percentage.

When real estate investors put up a property in the real estate market, the capitalization rate presents an estimate for their return.

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The choice of ‘estimate’ is deliberate, as cap rate is only one of the indicators of a property’s profitability.

As a real estate investor, depending on only the cap rate percentage might be unadvisable. Many times, the actual value of your property and other market conditions also come into play.

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What is the Cap Rate Formula?

The most common cap rate formula is: Net Operating Income / Property Value

The property value can equally be regarded as the current market value of the investment. Calculating the capitalization rate this way allows investors to determine their income following a year of real estate investing.

While the net operating income represents the expected or potential income after a year timeframe, the property value refers to the actual market price of the property.

To get the net operating income of an investment, deduct the costs of maintaining the property. Such expenses include taxes and regular maintenance charges. 

Let’s say an investor expects an annual income of $100,000 and he deducts the cost of operating expenses which is $20,000. That leaves him with $80,000.

If the market value of a property remains at $1,000,000, the cap rate is $80,000/$1,000,000 = 8%.

While this capitalization rate may look good, factors such as rate of tenant payment, market value, and annual demand may alter the percentage overtime.

Thus, different situations can influence the market income, taking it higher or lower.

Do You Want a High or Low Cap Rate?

Making a decision about a high or low cap rate depends on certain factors. Many investors assume that a higher cap rate is always better. But this is not always the truth.

One way to look at it is: Low cap rate = higher value and lower risk

            High cap rate = lower value and higher risk

Yes, this annual return on investment (ROI) metric is often used by long term investors including property owners and buy and old investors. Landlords often prefer low cap rates (since property value is high) while buyers/investors prefer high cap rates because the property has a lower value.

Nonetheless, a single year’s capitalization rate is insufficient to determine your return on investment in the coming years.

Another important thing to note is that properties with low cap rate could enjoy long term value creation. This, therefore, implies that low cap rate could bring higher profits on the long run when compared to properties in the high cap area.

Ultimately, when trying to decide whether to choose properties with high or low capitalization rates, it’s safer to look beyond the numbers or percentages. Consider the rents and expenses involved in investing in a particular property.

More importantly, always remember that high cap rates signal higher risks for an investment.

What is a Good Cap Rate?

Defining a good cap rate is closely linked to your purpose for measuring profit. Are you a property owner or seller? Or are you a buyer or investor?

Generally, a good capitalization rate for an investment is one that fits nearly accurately with other properties in the real estate market.

It looks specifically at similar properties within the same market, and which have recently been sold or on sale.

Any measurement that goes against these three key factors can be described as a bad cap rate. Plus, a good cap rate exceeds 4%. In fact, some individuals define a higher cap rate as anything between 8-10%.

Nevertheless, your aim as an investor should be your guiding force for figuring out what a good cap rate is. As subjectivity is important here, your real estate investing strategies cannot be underemphasized.

What kind of property are you interested in – multifamily property or commercial buildings? Also, what is the demand in the current market? Thirdly, what are the chances that there’ll always be tenants to pay the annual rents?

According to Andrew Campbell of Wildhorn Capital, the investor determines what good or bad cap rate means. Hence, it’s recommended that you look beyond the high or low cap rates to other vital factors such as the possibility of rent rate increase and the actual rent (not expected rent).      

What is a Good Cap Rate for Apartments?

Most smart investors consider factors such as location, demand, and property type before concluding on a good capitalization rate for apartments.

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Rental properties are assessed based on their urban or suburban location and the market (accessibility to highways, employment, and industries among others).

As a result, there is no one-size-fits-all cap rate for apartments. Unlike industrial hotel and retail assets, multifamily properties will always generate income.

The economy or even recession may affect business owners and companies, thereby making it impossible for them to run their businesses.

But as people will always need shelter to accommodate and protect their families, the potential for income with apartment is always high.

Payment from tenants will continually keep the return on investment up. A little delay in payment won’t have any major impact on profitability.

To further illustrate this, apartments in high-demand metropolitan cities such as New York may have about 4% cap rate. But apartments in rural or upcoming areas may have up to 10% cap rate.

How to Use Cap Rate for Real Estate Investing

In using the cap rate for real estate investing, investors gain insight. For one, considering and comparing the capitalization rate of one property to another within the same market allows you to evaluate the risk levels.

To illustrate this, a property with 4% capitalization rate may prove less risky than another investment with 11%.

Also, measuring the capitalization rates of different property types over a period of years provides information about the direction of the market. Such estimates can help you to decide what the market trends will be in future years.

A third use of capitalization rate in the commercial real estate industry is to compare investments. With a high cap rate for multifamily buildings, an investor might ignore rentals or recreational property.           

How do You Calculate Cap Rate?

To calculate the cap rate, you need to deduct the operating costs of the property from your expected profit.

Imagine a property’s annual revenue is $70,000 and the expenses take $20,000 of this amount. That makes $50,000 the Net Operating Income (NOI).

As for the market value, you may have $800,000. $50,000 divided by $800,000 = 0.0625% or 6.25%.

With a 6.25% annual capitalization rate, you can be sure that a property is worth your investment.

What Factors go into Cap Rate?

As already established, when measuring cap rate, you should take note of the following:

1. Market Value
2. Property Type
3. Location of the investment
4. Occupancy rate
5. Age of the property
6. Rate of tenant rental payment
7. Economic realities and policies

These factors contribute to the credibility and profitability of an investment within a year and over a longer period. 

How Property Type Affects Cap Rate

Different property types equal different levels of risk, and ultimately different cap rates. The most popular property types include:

• Apartment buildings
• Hotels
• Recreational properties
• Multifamily property
• Retail/Commercial real estate properties
• Single family home
• Condo and townhomes

Generally, property types which involve regular and consistent occupancy rate produce higher capitalization rates and lower risks. As with apartment buildings, for example, an investor can expect to get a high cap rate because tenants rent will most likely always be paid.

However, such a level of assurance is uncertain with hotels, retail properties or recreational buildings. Such businesses could be affected by economic policies and business owners may go out of business or find it difficult to pay rentals.     

What is a Good Cap Rate for Rental Properties?

A good idea of the rental income will help you figure out what a good capitalization rate is. While it is somewhat difficult to place one’s finger on a specific cap rate, it is possible to assume that properties with 8% – 12% cap rates are worth your investment.

Factors you should, however, pay attention to include the location of your rental property, your rental strategy, and the cost of managing the property.

When you have successfully compared all three factors for different properties, you can estimate your expected return on investment. Likewise, you can guess how long it will take you to regain your investment.

The Bottom Line

In sum, cap rate is essential for determining the profitability of any investment. Yet, you should assess other factors before investing in any property.

How has assessing capitalization rates improved your investment choices? Feel free to share.