The cap rate, also known as the capitalization rate, is a number that real estate investors use to evaluate the return on investment in a property. Although it is not the only factor you should consider when making a real estate purchase, it can help you quickly compare properties.
Today, we will take a closer look at exactly what a cap rate is and why it is a useful number for you as a real estate investor. With that, let’s dive right in!
What is a Cap Rate?
The cap rate is the result of a formula that many real estate investors use to evaluate the profitability of a property.
Simply put, the cap rate is the ratio between the net operating income to the property’s value. Essentially, it is the percentage of investment return that that property will generate each year.
How to calculate net operating income
In order to calculate the cap rate, you’ll need to know what the net operating income (NOI) is. The net operating income is the revenue of a property minus any operating expenses.
You can determine what the net operating income of a property is by subtracting your expected expenses from the gross rental income. Some expenses to consider include any vacancy losses, taxes, insurance, repairs, utilities that you are responsible for, and more.
Make sure to think through all possible expenses to accurately calculate your net operating income. Otherwise, you might throw off your calculations.
Does the cap rate include the mortgage?
The formula assumes that the property was bought in cash. It is important to note that the cap rate formula does not include the financing of the deal. So, if you took out a mortgage to buy the property, then you will need to consider that factor separately.
Cap rate formula
Now that you know how to calculate the net operating income of a property, you are prepared to calculate the cap rate.
How do you calculate a cap rate?
Here’s the simple formula:
Cap rate = Net Operating Income/Purchase Price
Let’s take a look at a few examples. We will walk through three separate examples so that you can get the hang of this calculation.
You are considering buying a property in cash for $100,000. Once you take ownership, you plan on making $50,000 worth of renovations to update the property and fetch a higher rent. You plan to rent out the property for $2,000 per month. In terms of property expenses, you expect to spend $250 per month to keep the property well maintained. Here’s how you would calculate the cap rate on this deal:
First, determine the total upfront investment. In this case, you would add $50,000 of renovation costs to the purchase price of $100,000. That leads to an upfront cost of $150,000.
Next, calculate your net operating income. In this case, you would bring in $2,000 per month. But you’d be spending $250 on monthly operating expenses. That would lead to a monthly net operating income of $1,750. You will multiply that number by 12 to calculate the annual net operating income. For this property, the annual net operating income would be $21,000.
Finally, you will divide the net operating income by the price of the investment to get your cap rate. So, you would divide $21,000 by $150,000 and multiply that outcome by 100. That leads to a cap rate of 14%.
Let’s say you are considering buying a rundown multi-family property in cash for $250,000. Once you take ownership, you plan on making $250,000 worth of renovations to make the property livable and rentable to desirable tenants. You plan to rent out 4 units in the property for $1,500 per month each. In terms of property expenses, you expect to spend $300 per month to keep the property well maintained. Here’s how you would calculate the cap rate on this deal:
First, determine the total upfront investment. In this case, you would add $250,000 of renovation costs to the purchase price of $250,000. That leads to an upfront cost of $500,000.
Next, calculate your net operating income. In this case, you would bring in $6,000 per month. But you’d be spending $300 on monthly operating expenses. That would lead to a monthly net operating income of $2,400. You will multiply that number by 12 to calculate the annual net operating income. For this property, the annual net operating income would be $28,800.
Finally, you will divide the net operating income by the price of the investment to get your cap rate. So, you would divide $28,800 by $500,000 and multiply that outcome by 100. That leads to a cap rate of 5.76%.
Let’s say you are considering buying a luxurious single-family property in cash for $250,000. Once you take ownership, you don’t foresee a need to make any dramatic renovations. Essentially, the property is turnkey. Once tenants move in, you will be able to charge $3,000 per month. In terms of property expenses, you expect to spend $150 per month to keep the property well maintained. Here’s how you would calculate the cap rate on this deal:
First, determine the total upfront investment. In this case, you would only need to consider the purchase price of $250,000. That leads to an upfront cost of $250,000.
Next, calculate your net operating income. In this case, you would bring in $3,000 per month. But you’d be spending $150 on monthly operating expenses. That would lead to a monthly net operating income of $2,850. You will multiply that number by 12 to calculate the annual net operating income. For this property, the annual net operating income would be $34,200.
Finally, you will divide the net operating income by the price of the investment to get your cap rate. So, you would divide $34,200 by $250,000 and multiply that outcome by 100. That leads to a cap rate of 13.68%. This cap rate is very similar to the one in the first example which shows that properties of various purchase prices can have a very similar cap rate.
The key to an accurate calculation is to determine what the net operating income is. There are many variables that could affect your net operating income, so make sure to nail down that part of the equation.
PRO TIP: You very rarely see cap rate used in a single-family home, even if it is being used as a rental. You see cap rate used more for small multifamily and commercial properties.
What does the cap rate tell you?
Once you’ve determined what the cap rate of a property is, you’ll need to be able to interpret that number. After all, a percentage without any context will not be very helpful.
The cap rate is basically a measure of risk. With that, you can interpret that a higher cap rate will equate to a more risky investment. On the opposite end, a lower cap rate indicates a less risky investment. The more you use the cap rate formula within a particular market, you’ll have a better handle on interpreting the formula.
The cap rate can also shed some light on how long it will take to recoup your initial investment. For example, if you find a property has a cap rate of 5%, then it will take around 20 years to recover the initial investment.
Factors that affect the cap rate
A cap rate is not a static number that remains unaffected by market conditions. Instead, it will be influenced by several factors. Here are some of the major influencing factors that you need to be aware of:
Micro and macro market influences
The geographic real estate market will play a role in determining a cap rate. That is because this factor will be influenced by micro and macro market conditions.
For example, a high cost of living areas such as Seattle will likely have lower cap rates. The lower cap rate indicates to investors that there is a lower risk associated with the investment in that area. This makes sense because these urban centers with strong economies are less likely to cause problems for the investor.
On the flip side, the low cost of living areas in more rural areas are often associated with a higher cap rate. That is due to the fact that these areas present more risk to an investor. After all, a smaller and less diverse economy puts a real estate investment at greater risk.
Beyond the widespread geographic differences, micro influences in your local market will have an impact on the cap rate. You may already know that properties can be categorized as class A through D, with A being the nicest and newest properties in the best neighborhoods. Class A neighborhoods in a particular market are usually associated with less risk. With that, you should expect class A neighborhoods to have a lower cap rate than a class D neighborhoods.
When you think about the risks associated with class D neighborhoods, it makes sense why you should expect a higher cap rate. You are running a higher risk with that purchase, so the potential reward is higher.
The type of property
As you venture into real estate, you’ll quickly realize that the type of property will greatly influence the cap rate. You’ll run into a large difference between residential and commercial investments. Plus, differences across properties of various shapes and sizes.
For example, a small multifamily home in a popular area of the city will likely have a lower cap rate than a retail location. The differences across properties will create different levels of risk which will be apparent when you calculate the cap rate of a property.
The real estate market, in general, is greatly affected by changes in interest rates. When the Federal Reserve makes changes to the rates, ripple effects can be seen throughout the market. With that, it is possible for interest rates to affect cap rates.
When the Fed increases the interest rates, then property values will generally fall. That is due to the fact that it is more expensive to borrow funding when interest rates are rising. Since property values are affected by these changes, the cap rate will also be affected.
It is equally possible for the Fed to reduce interest rates. That could lead to a rise in property values because funding is easier to come by. Plus, it is less expensive to secure funding.
How to use cap rate as a real estate investor
You might be wondering why you’ve heard so many real estate investors mention the importance of calculating the cap rate. Of course, the idea of calculating a cap rate sounds like a good idea. But why is this formula so useful to investors?
The reason why this seemingly small piece of information is so useful to investors is the ability to analyze properties. As you consider any real estate investment, you need to consider the overall risk factors. But a quick calculator of the cap rate can help you understand some of the risks without too much upfront research.
If the cap rate sounds good, then you can continue to investigate the property. If the cap rate doesn’t fit into your portfolio’s goals, then you can move on without wasting any time on the property.
The best uses of the cap rate formula can help you analyze a market for opportunities, set goals for your property acquisitions, and make decisions on the liquidation of properties.
PRO TIP: When you are looking at a property for sale, and they list a cap rate, do not take it for face value. Most sellers and their brokers tend to minimize the property expenses listed to increase the NOI. This turn makes the cap rate more attractive. Make sure to verify the accuracy of what they provide.
What is considered a ‘good’ cap rate?
Now that you know what a cap rate is, you probably want to know exactly what a good cap rate is. Unfortunately, like so many numbers in real estate, this answer will vary widely based on the market you are investing in. Plus, your personal risk tolerance will affect your idea of what exactly a good cap rate is.
Let’s cover a few common questions to get a better idea of what a good cap rate is.
Is it better to have a high or low cap?
As we mentioned, a cap rate is a measure of risk in your investment. A high cap rate will indicate a higher risk. However, it will also indicate a higher potential return and the possibility of recovering your initial investment quickly. On the other end, a low cap rate will represent a property with lower levels of risk involved. Additionally, it will indicate a lower potential return and a longer timeline for recouping your initial investment.
With this in mind, a ‘good’ cap rate will vary depending on the location of a property. You might be comfortable working with lower cap rates in markets that are confidently on a trajectory of growth for decades to come. But you might require a higher cap rate to work in a market with less stability and promise for growth.
Generally, you’ll want to pick a range of cap rates that you are comfortable working with. You want to make sure that your investments will be a worthwhile way to build wealth. But you probably don’t want to take on more risk than is absolutely necessary.
You will have to determine for yourself what a good cap rate is for you. Yes, a higher cap rate has more potential for return. But a lower cap rate presents a safer investment. There is no right or wrong choice between the two. You can choose what you would consider a reasonable cap rate within your own portfolio based on your market and risk tolerance.
What does a 7.5% cap rate mean?
A 7.5% cap rate means that the property’s ratio of net operating income to the purchase price is 7.5%. For example, let’s say you bought a property for $100,000 and had an annual net operating income of $7,500. That means that the cap rate of this property is 7.5%.
With this, you should expect that it will take over 13 years to recoup your initial investment. But it will not tell you anything about the cash flow of a property if you are considering your financing options.
A cap rate of 7.5% alone doesn’t tell you whether or not this property is a good investment. You’ll need more information about the surrounding market conditions to compare this cap rate against. Once you have a market average to compare this cap rate to, you can determine if the cap rate is suitable.
The bottom line
Overall, a cap rate is a useful number to help you make decisions as a real estate investor. Although the cap rate should not be the number in which you pin all real estate purchases, it should be a factor that you consider. Beyond the cap rate, you should also consider the condition of the property, the cash flow potential, and the 1% rule. You’ll want to consider a robust set of factors before making a decision to purchase a property.
If you want to build a real estate portfolio, then check out our other useful resources. FI by REI is here to help you build the real estate portfolio that will propel you to financial independence!
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