What Is Cap Rate In Real Estate And How To Calculate It?

In real estate, Cap Rate (Capitalization Rate) is calculated by dividing your Net Operating Income (NOI), by the market value of a property. It can be used to determine an investment’s potential.

The rental property cap rate is a simple way to determine if a real estate investment opportunity has the potential to achieve your financial goals or not.

In real estate investing, the cap rate is a metric that is used to forecast the return on investment (ROI) of a property. It is calculated as a ratio of net income to capital costs or current value and expressed as a percentage.

Understanding a rental property's cap rate allows investors to determine whether or not the property is going to be profitable and assess how it stacks up to similar properties in the area.

What Is Capitalization Rate in Real Estate?

Capitalization rate, often referred to as the cap rate, is a metric used in real estate that indicates the rate of return that is expected from an investment property. 

The cap rate is calculated by dividing the property's net operating income (NOI) by the asset value and is expressed as a percentage. This figure assists in gauging the potential return for real estate investors and can also be used to make predictions of the final capitalization rate, or terminal cap rate, when the property is sold.

While the cap rate provides a quick means of comparing similar real estate investments, it's essential to note that it shouldn't stand alone as the sole indicator of an investment's viability. It doesn't consider elements like leverage, the time value of money, or future cash flow from property enhancements, among other significant factors.

Understanding Cap Rate on Rental Property

The cap rate is one of the most popular metrics investors used to assess a rental property’s profitability. Put simply, it represents the yield of a property over a one-year time horizon.

The capitalization rate reflects the property's inherent, unaltered rate of return, independent of leverage.

The Capitalization Rate Formula

There are multiple methods to calculate the capitalization rate in real estate. The most commonly used cap rate formula involves dividing the property's net operating income (NOI) by its current market value. 

Cap Rate Formula

Capitalization Rate = Net Operating Income / Current Market Value​

Here's a breakdown of the components of the above cap rate formula:

Net operating income (NOI) represents the anticipated annual income generated by the property, such as rental earnings, after subtracting all management-related expenses. These expenses encompass regular facility maintenance costs and property taxes.

The current market value signifies the property's present-day worth based on existing market rates.

An alternative approach involves computing the figure based on the property's original capital or acquisition cost:

Capitalization Rate = Net Operating Income / Purchase Price

​However, this method isn't as popular due to a couple of reasons. Firstly, it tends to yield unrealistic outcomes for older properties bought years or decades ago at lower prices. Secondly, it isn't applicable to inherited properties since their purchase price is zero, making division impossible.

Given the considerable fluctuations in property prices, the first formula utilizing the current market value is a more accurate representation compared to the second, which relies on a fixed, original purchase price.

How to Calculate Cap Rate in Real Estate

There are a few simple steps to take to determine your property’s cap rate.

Step 1: Determine your annual net operating income (NOI).

To do this, you will need to estimate expected rent amounts and include any additional income sources, such as rented parking spaces, laundry facilities, etc. You can conduct a market analysis on similar rentals in the area to determine a realistic rent rate.

Once you have your gross income, you will need to deduct operating expenses (excluding mortgage payments). These expected operating expenses will include things like property management fees, homeowner association dues, taxes, insurance, and so forth.

For example, you are looking at a single-family home that you expect to rent for $1,800 per month. This would equal $21,600 annual gross income.

Your operating expenses might then equal 40% of that income, so $720 per month or $8,640 annually.

Your total operating income would then be $12,960 (before mortgage payments).

Step 2: Determine asset value.

There are a couple of ways to establish this. You can, for example, use Zillow Zestimates to get a rough idea of the current valuation of a property. Or you could contact your broker or an appraiser to get a more accurate idea of the property’s current market rate.

For this exercise, let’s say it’s a single-family home worth $250,000. Once you have this property valuation you’re ready to move on to the next step.

Step 3: Calculate your cap rate

To calculate your cap rate, you need to divide your net income by your asset value.

If we use the values in our example, that would be:

(12,960 / 250,000)x100 = 5.2%

We can use this simple formula to find properties with the best cap rates, which in turn, give us the best ROI.

Factors That Impact Cap Rates

The cap rate for rental properties is a crucial tool for making informed investment decisions. However, it’s not perfect and there are numerous elements can impact the cap rate that should be considered when setting your cap rate target. 

A few of these factors include:

• Location: Where the property is based can hold a substantial sway over the purchase price and rental rates.
• Market Size: Larger, more competitive markets tend to yield lower cap rates compared to smaller markets, where risks might be higher.
• Asset Stability: The projected stability of a property's value contributes significantly to cap rate considerations.
• Growth Potential: Properties with substantial growth potential within burgeoning markets can impact cap rates.
• Capital Investment: The amount of capital invested directly influences the Net Operating Income (NOI), thereby affecting the cap rate.

These factors, amongst others, wield significant influence over the cap rate and risk profile of an investment. Investors should consider as many factors as possible before making any investment decisions.

How To Use Cap Rate To Assess Rental Property

It’s all very well to crunch the numbers and get your estimated cap rate. But if you don’t know what to look for, know what a good cap rate is, and know how to compare properties then calculating your cap rate is a largely pointless exercise.

Generally speaking, a higher cap rate is a riskier investment but is also likely a more profitable one.

It’s important to note though that you can’t simply set a blanket target cap rate, as cap rates will vary broadly in different locations. As such, you should run a cap rate analysis on several other similar rental properties in the area to give yourself a benchmark.

The target cap rate you look for has to take into account key factors, such as location, demand, and economic stability of the area (for example, how available are jobs?).

When Should You Not Use The Capitalization Rate?

Capitalization rates serve as a powerful tool for real estate investors to assess potential rental property investments. However, as mentioned already, it’s not without its flaws and limitations. A few situations where applying the cap rate metric might be limited include:

• Inconsistent Income History: If a property, such as an apartment building used for short-term vacation rentals, lacks a consistent income history, the cap rate formula might not effectively predict its investment value. In such cases, employing a cash flow model could offer a more accurate estimation of returns.
• Financing Methods: The cap rate formula doesn't generally take into account leverage. When considering a mortgage to finance an investment, the cap rate may not provide the most suitable metric.
• Long-Term Uncertainty: Cap rates hinge on the assumption of long-term income stability. However, they fail to consider potential future risks like depreciation or market shifts that could lead to income fluctuations.
• Renovations: The cap rate doesn't take into account any potential additional investment that might be made into the property. If you're planning to renovate the property to increase its value and rental rates the cap rate may not be the best metric.

What Is A Good Cap Rate?

Some investors won’t touch anything with a cap rate of less than 8%. Others aim for higher still, looking for double figures hoping to achieve a maximum ROI.

However, it depends on how comfortable you are with risk, your long-term goals, and of course the location that you’re investing in. For example, if you wanted to invest in San Francisco you simply won’t achieve a 10% cap rate no matter how hard you look.

People who don’t want excessive risk but still want to achieve a respectable ROI will often look for a cap rate of between 4-6%. This range offers a reasonably good yield and enough stability for you not to feel nervous about potential cash flow issues.

Related: Free Rental Yield Calculator

How To Save Time and Improve Portfolio Profitability

Whatever your goals are, whether it’s simply to generate a little income on the side, to build a nest egg for retirement, or you want to build wealth and achieve financial freedom, the most important aspect is time.

The more time you’re managing your rentals the less time you have to scale, travel, or spend time with family and friends.

Modern real estate investors then are always looking for software and automation tools to help them gain control over their portfolios, save time, and improve operational efficiencies.

Landlord Studio, allows users to easily track income and expenses via their mobile device or desktop. Use time-saving features such as smart scan receipts which allows you to digitize receipts at the point of sale and the software automatically extracts the receipt data and creates the expense for you, and connect your bank feeds to view and reconcile transactions in real-time.

Additional features include property maintenance management, tenant screening, and online rent collection, which enables tenants to automate their rent payments. All income collected through online rent collection is automatically tracked in our income tracker. Automate tenant communications, set reminders for yourself, and more.

Final Words

Every investor has different circumstances and goals and so you need to adapt your strategy accordingly. A good cap rate for some might not be so good for others. There are numerous determining factors to consider before you make an investment decision. The cap rate is only one metric that you can use to get a quick assessment of a prospective rental property.

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• 11 Real Estate Investing Metrics that Investors Need to Know

Cap Rate FAQs

What is a Good Cap Rate?

A good cap rate for an investment property typically falls within the range of 4% to 10%. However, pinpointing the exact figure hinges on the property's location and the necessary rate of return to deem the investment financially viable. Some areas with higher purchase prices, for example, might achieve lower cap rates in general but cash flow better and achieve better long term capital gains.

What is a Bad Cap Rate?

There’s no single number that can be used as a bad cap rate, just as there aren’t any universal numbers for a good cap rate. However, one way to look at it is a bad cap rate would be anything that is lower than the cap rate of a similar property. Again, keep in mind that the property with a lower cap rate might possess long-term potential if enhancements can be made to reduce expenses or boost income.

Is a Higher or Lower Capitalization Rate Better?

Generally, the capitalization rate can be viewed as a measure of risk. A higher cap rate suggests greater investment risk (but higher profits), while a lower cap rate indicates lower risk (with lower profits). The investor's risk tolerance and profile significantly shape whether a higher or lower cap rate is perceived as favorable.

What Is the Difference Between the Capitalization Rate and Return on Investment?

Return on investment forecasts the potential returns an investment might yield over a defined period. Whereas, the capitalization rate reveals the current return of an investment or its expected yield.

Is Cap Rate the Same as ROI?

No, though they may seem similar cap rate doesn't directly equate to ROI. Return on investment (ROI) is a versatile metric that assesses the returns relative to the initial investment across various scenarios. Cap rate operates as a percentage figure indicating a property's potential to generate a strong ROI.

What is the Purpose of the Cap Rate Calculation?

In real estate, the cap rate calculation serves as a crucial tool aiding investors in assessing the viability of a deal. It enables them to gauge a property's value and potential returns, making it easier to compare like-for-like properties, and aiding in informed decision-making when pursuing real estate opportunities.

Why is a Real Estate Cap Rate Important for Property Investors?

Much like a savvy shopper aiming for the best price, real estate investors are looking for properties that promise the best cash flow. The cap rate formula becomes instrumental in their decision-making, enabling them to discern which property holds the potential to make the most profit.

What is the Difference Between Cap Rate and Yield?

While the yield percentage of a property is calculated by dividing its annual income by its total cost, the cap rate measures income divided by the property's price or value. 

Unlike the cap rate, yield doesn't solely reflect cash flow. Yield, often termed as a rate of return, encompasses broader considerations like leverage and rental property tax deductions, and can help investors get a more comprehensive evaluation of a property's overall cost.

How do Cap Rates Vary Between Urban and Suburban Areas?

Cap rates are dependent on real estate prices, along with rental rates, both opf which are influenced by broad economic factors. Consequently, distinct regions exhibit differing cap rates determined by the local economy, property values, and average rental rates. As such, when comparing rental property cap rates it’s important to only compare similar properties in comparable neighborhoods. There’s no point comparing a New York City property to one in small-town Ohio.

What are the Disadvantages of Using Cap Rate to Analyze an Investment?

The cap rate serves as a quick way to assess a property’s performance. It however, only looks at current data and doesn’t take into account local investment in the area, potential growth of the housing market, or renovations the investor makes. By only looking at cap rate then you could potentially miss hidden gems. 

What is Cap Rate Compression?

The capitalization rate, derived from dividing the net operating income by the purchase price, defines the stability of real estate assets. However, real estate values aren't always constant; they fluctuate based on factors like vacancy rates, neighborhood dynamics, and market conditions. When a property's value rises, dividing the annual net income by the purchase price results in a decreased percentage, leading to a lower cap rate. This phenomenon is termed cap rate compression.

Debate exists among real estate investors regarding whether cap rate compression indicates higher or lower risk. On one side, it signifies the property's ascension as an appreciating asset class. Conversely, it can pose challenges for new investors aiming to enter the market, potentially necessitating cash purchases if securing favorable lending becomes challenging amidst cap rate compression.