What Does Cap Rate Mean?
The cap rate is a percentage that indicates the expected annual return on a real estate investment based on the property's income. It is essentially one way to measure how valuable a potential real estate investment might be based on its overall profitability or return potential. Cap rate is calculated using the following formula: Cap Rate = Net Operating Income (NOI) divided by Current Market Value or Purchase Price × 100.
How Do Cap Rates Work?
Investors also frequently use the cap rate measuring method to investigate potential investment risk. Higher cap rates usually mean that an investment is riskier, while the reverse is true for lower cap rates.
Many real estate investors use the cap rate calculation method to quickly check the relative or “good enough” value of various real estate investments that are similar to one another. For instance, you can use the cap rate to check two houses against one another if they are in the same part of town and have similar general asset values.
Using Cap Rate
Investment Comparison
- The cap rate allows investors to compare the profitability of different real estate investments regardless of their size or type.
- A higher cap rate typically indicates a higher return and potentially greater risk, while a lower cap rate suggests a lower return and potentially lower risk.
Risk Assessment
- Cap rates can help assess the risk associated with an investment. Properties in high-demand, stable areas tend to have lower cap rates, reflecting lower risk.
- Properties in less desirable or more volatile areas often have higher cap rates, indicating higher risk.
Market Trends
- Cap rates can indicate market trends and the overall health of the real estate market. Rising cap rates may suggest declining property values or increased risk, while falling cap rates may indicate rising property values or decreased risk.
Valuation Tool
- Investors use cap rates to estimate the value of a property. By knowing the NOI and desired cap rate, they can determine an appropriate purchase price.
How to Calculate Cap Rate
You can calculate the cap rate for a given piece of property by looking at the net income of the property should generate over a single calendar year. You find that net income by dividing the net operating income at the supposed time of purchase by the property’s total asset value, or current market value. The formula to calculate cap rate is Cap Rate = Net Operating Income / Current Market Value.
Note that the above formula doesn’t include the mortgage expenses that might be included within an investment property.
How do you calculate the net operating income?
Take the gross rental income for a given property and subtract:
- the property taxes
- property insurance
- maintenance and repair costs
- vacancy and credit loss reserve costs
- common utility costs
- any extra expenses like licenses
You’ll end up with the net operating income for a piece of property. As you can see, NOI is essentially how much income you can expect from a given property after you remove all the expenses needed to maintain the property at the same level of value.
Other Cap Rate Formulas
There are other ways to calculate the cap rate for a given property. For instance, you can calculate the cap rate by dividing NOI/purchase price, although this is significantly less popular among experienced investors. This is because older properties that were purchased quite some time ago may have prices that are irrelevant or inaccurate compared to the current market. Secondly, such a formula can’t be applied to any inherited property since the purchase price is zero.
Still, you can use this version of the formula if you’re looking at a piece of property that will be purchased from the market standard price.
Cap Rate Examples
Say that you’re looking at an investment opportunity for a property that costs $1 million and has an NOI of $70,000. The cap rate would be 7%, and the formula you'd use would be as follows:
- $70,000/$1 million = 0.07 or 7%
Then you could compare another property that is pretty similar but has a much smaller NOI at just $50,000, with a similar purchase price or net value of $1 million. In this instance the cap rate would be just 5%.
- $50,000/$1 million= 0.05 or 5%
In the above example, the first property would be a better investment according to the cap rate since it provides a slightly higher return on investment. Remember, the NOI is the breakdown of the money you have leftover after subtracting all the operating expenses to maintain a piece of property.
What Is a Good Cap Rate?
A “good” cap rate will usually hover around 4% or so for most real estate properties – the above example just shows you how to use the formula. For instance, an actual property purchase might be something closer to:
- a property priced at $1 million
- NOI at $40,000
- So the formula for a property with a good cap rate looks like this: $40,000/$1 million = 0.04 or 4%
Generally speaking, good cap rates usually imply lower risks, and lower cap rates imply low risks in most cases. Risk-averse investors will probably want to look at the properties with lower cap rates as a result.
However, keep in mind that a good cap rate is also heavily dependent on local market conditions. For a generally risky area, a higher cap rate might still indicate a good investment.
Cap Rate vs ROI
ROI or return on investment is another way to calculate whether a property is actually performing according to your expectations. But it’s not usually used to consider whether a property will be a good investment. In fact, it’s most often used for properties that investors already own. You can still use the ROI formula if you have lots of detailed numbers about a potential property.
The ROI formula goes like this:
- annual return/total investment
So a property with an annual return of $100,000 and a total investment of $1 million would have an ROI of 0.1 or 10%. That’s pretty decent, depending on surrounding market conditions.
Cap Rate Bottom Line
The cap rate is an essential tool for real estate investors, providing a straightforward way to assess the profitability and risk of investment properties. By understanding and applying cap rates, investors can make more informed decisions, compare different investments, and better navigate the real estate market. However, it is important to consider other factors and conduct comprehensive due diligence, as the cap rate is just one of many metrics used in real estate investment analysis. While knowing the cap rate is very useful, you should only use it as intended for actionable results.