Real Estate Cap Rate: Defined and Explained
The capitalization (cap) rate is a crucial part of residential and commercial real estate investing. It helps you determine if a property is worth investing in or if you should pursue a different one. The cap rate is key to any successful real estate investment portfolio. In this article, we will break down what the cap rate is and how it works.
What is the Cap Rate?
The cap rate is used to determine the rate of return that you can anticipate getting when you invest in residential and commercial real estate properties. It is based on the new income that the property is anticipated to earn and the operating expenses. You can use it to compare the value of multiple properties that are similar to give you a quick indication of which one may give you a better return. Of course, the cap rate is only one factor that you should consider when comparing properties, as there are many other factors that should be compared before you invest.
How to Calculate Cap Rate
There are multiple versions of how to calculate the cap rate, so we will look at each of them here.
The most commonly used way to determine the cap rate is to divide the net operating income of the property by its current market value.
Net Operating Income / Current Market Value = Cap Rate
Another version of the cap rate is shown below, this version is unpopular because it often gives investors an unrealistic idea of the property value for an older property, and it cannot be used on an inherited property. This formula divides the net operating income by the purchase price of the property.
Net Operating Income / Purchase Price = Cap Rate
Examples of the Cap Rate Calculation
Let's look at an easy example of calculating the cap rate of a business. You are buying a property for $1 million that has a gross income of $100,000 a month through rent from tenants, and it has $30,000 in monthly expenses. The net operating income for the property would be $70,000. You then divide that by the purchase price of the property, and you have a cap rate of seven percent.
$70,000 / $1,000,000 = 0.07
0.07 x 100 = 7%
Factors That Impact Cap Rates
There are a few things that can impact the cap rate of a property that are important to keep in mind.
- Location: If the business is in a risky location, the cap right will probably be higher.
- Growth Potential: The amount of potential for growth in the business impacts the cap rate.
- Stability: The property's projected stability can impact the cap rate.
- Market Size: A smaller, less competitive market where more risk is involved is going to have a higher cap rate than a business with a bigger market.
- Liquidity: The amount of capital you will be putting into the property can affect the cap rate since that impacts the net operating income.
- Property Type: The type of property will determine any risks, the potential return, and expenses, which all factor into the cap rate.
- Interest Rates: When interest rates go up, cap rates also usually go up too.
How is the Cap Rate used?
The reason that the cap rate is so important for investors is because it can help them determine how high of quality a potential investment is. While it is not the only factor to consider when buying a residential or a commercial property, it can help an investor make the best decisions for their portfolio when combined with other factors. If, for example, you are debating between two properties, the cap rate can help you decide which one is riskier than the other, so you can choose the better property.
Cap Rate Calculator
This cap rate calculator helps you estimate the cap rate based on the value of a given rental property and the income from renting it. You can use it to decide whether a property's price is justified or determine the selling price of a property you own.
What's a Good Cap Rate?
There is no concrete number that indicates something is a good or bad cap rate. A higher cap rate means that it is a riskier venture, but you may be able to recoup your initial investment quickly. A lower cap rate usually indicates a less risky for you as the investor, but it means that it may take you longer the fully get back your investment. A good or bad cap rate depends on if you as the investor want to take on a riskier property that may have better rewards or lower risk. Many investors prefer a cap rate between five percent and ten percent, depending on the amount of risk they want to take on and the area the property is in.
When should you use a cap rate?
Real estate investors use cap rates when they are comparing the risks between multiple residential or commercial properties to invest in. It is great for purchasing any investment property.
When not to use a cap rate
You should not use the cap rate when you are trying to determine the value of a property with an irregular income stream, a single-family home, or a property you plan to flip quickly.
Cap Rates for Vacation Rental Homes
You can use the cap rate for a vacation rental home, and it is calculated the same way we mentioned above, except that the property value is determined based on comparable properties in the area that were recently sold. The cap rate will also help you determine how much money you can charge for rent in rent in order to cover operating expenses and gain a profit.
What Is the Difference Between the Cap Rate and ROI?
Both the cap rate and return on investment (ROI) are used for investing, but the difference between the two is how each of them is used. The cap rate tells you your ROI based on the property's current market value. The ROI indicates the potential return over the lifetime of the investment.
Be sure to check out our other guides on important investment metrics such as a property's cash-on-cash returns and internal rate of return as well.