When you’re evaluating a new property for your real estate portfolio, you may need to compare two similar properties or figure out whether a property has a good potential to return on your investment. Let’s break down how cap rates work in real estate.
Cap rate is short for capitalization rate, and it is essentially one way to measure how valuable a potential real estate investment might be based on its overall profitability or return potential. A property’s cap rate represents how much the property will yield over one year, assuming that the property is also purchased in cash (or outright) instead of with a loan.
Such a representation indicates the intrinsic, unleveraged, and natural rate of return for a given real estate investment.
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 one-story, three-bedroom houses against one another if they are in the same part of town and have similar general asset values.
However, the cap rate measurement method is not extremely precise, and it should never be used as the sole indicator of the strength of an investment. There are plenty of weaknesses to cap rates in real estate. For instance, the cap rate doesn’t take into account leverage, and it also doesn’t account for how much money and future cash flow might appear because of different property improvements or other investments.
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.
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. Put another way, the main cap rate formula is:
- Net operating income(NOI)/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.
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.
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.
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.
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.
All in all, cap rates can be valuable measurement tools if you want to estimate the potential return on investment that a property can bring to your portfolio. However, there are other analytical tools you can and should use, and the cap rate is only valuable for generalist comparisons between similar properties. While it is very useful, you should only use it as intended for actionable results.