The capitalization rate, or cap rate, is often used by real estate investors to determine the potential rate of return from a property. While it can be used to figure out if a property will yield enough of a profit, it does have its limitations and should be only one of several methods used to determine if an investment property is a good deal. The cap rate is calculated like so:
Cap rate = Net operating income / Current property value
You can use our calculator below to compute a property’s cap rate:
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Cap Rate Calculation Examples
Below is an example of how the cap rate is calculated for two different properties. As you can see, it’s important to take into consideration not only the property’s value and income but also any expenses associated with maintaining the property.
Property 1 | Property 2 | |
|---|---|---|
Income | ||
Annual Income | $40,000 per year | $60,000 per year |
Annual Expenses | ||
Property Management Fees | $1,000 | $2,000 |
Property Taxes | $5,500 | $9,375 |
Maintenance & Other Costs | $2,000 | $3,000 |
Homeowners Association (HOA) Fees | $500 | $0 |
Insurance Costs | $2,000 | $3,000 |
Utility Expenses | $1,500 | $2,500 |
Cost of Repairs | $2,000 | $3,000 |
Total Expenses | $14,500 annually | $22,875 annually |
Final Cap Rate Calculations | ||
Net Operating Income (Calculated as Income Minus Expenses) | $40,000 - $14,500 = $25,500 | |
Property Value | $500,000 | $750,000 |
Cap Rate | $25,500 / $500,000 = 5.1% | $37,125 / $750,000 = 4.95% |
When figuring out net operating income (NOI) for your cap rate calculation, exclude debt-related expenses, such as mortgage payments and fees incurred for getting a loan. You can use our NOI calculator to help with this calculation.
When calculating a property’s cap rate, it’s important to use the most accurate figures for NOI. For example, you may want to be conservative and apply a vacancy factor for the income you expect the property to receive. Similarly, you should consider expenses you may incur over the lifetime of owning the property. This can include things like repairs, which may not be required until after your first year of ownership.
Why Cap Rate Is Important
Cap rate can be used to compare different properties for the purpose of figuring out which one may yield the highest return on investment (ROI). Depending on your risk appetite, you can use it to guide your decision in choosing between a safer investment with lower returns, as opposed to one that may be a higher risk with a greater ROI. You can do this by considering the best and worst-case scenarios for income and expenses to see how it would affect the cap rate.
What Is Considered a Good Cap Rate?
As a general rule of thumb, a cap rate of 4% or higher is considered desirable. However, this depends on a number of factors, such as the property’s location and your risk tolerance.
Higher cap rates are associated with properties that can carry a greater level of risk. This is because high cap rates are often an indicator of a lower property value. With less expensive real estate, investors should be prepared for things like volatile property values, greater difficulty in attracting tenants, and maintaining high occupancy rates throughout the year.
Similarly, lower cap rates are associated with safer investments. More expensive homes tend to be located in desirable areas, which usually means investors will have an easier time finding tenants and maintaining a high occupancy rate year-round.
Factors That Affect the Cap Rate
A property’s value is a big determining factor of its cap rate. While this can be obtained through traditional means, such as obtaining a formal appraisal inspection, the following are factors that typically impact a property’s value and its corresponding cap rate calculation:
- Location: An attractive location draws in more tenants willing to pay a higher amount of rent. Properties close to amenities, such as shopping, entertainment, parks, highly rated schools, and employment centers, tend to be indicative of a more desirable property location.
- Features and amenities: A home’s features are another determining factor of the amount of rent tenants may be willing to pay. This can include things like the size of the home and the presence of a backyard, patio, or tennis court.
- Cost of financing: As rates increase and loans become more expensive, property values tend to decrease since the buying power for borrowers goes down. However, to improve your chances of getting the best rate possible, you can read our guide on how to get a small business loan.
- Housing supply and demand: Supply and demand of homes can be impacted by things like unemployment rates and other economic factors. With a higher unemployment rate, folks are less likely to be able to afford expensive housing, which can translate to lower market rents and property values.
Who Should Use a Cap Rate
You can use the cap rate to compare the potential risk and return on investment between multiple investment properties. Landlords and long-term investors of both residential and commercial real estate (CRE) can use the cap rate for a variety of properties, including
- Single-family investment homes
- Condominium and townhome rental properties
- One- to four-unit multifamily residential investment properties
- Five-plus-unit apartment buildings
- CRE investment properties
Who Should Not Use a Cap Rate
Cap rate should not be used on real estate that is not expected to generate rental income year-round. Doing so will result in a skewed figure and will not give you a reliable indicator of the risk level or potential return on investment. Here are some examples in which using the cap rate may not be appropriate:
- Vacation homes and short-term rental properties: Cap rate considers annual income, so properties that only generate rental income for several months throughout the year will not give you a reliable figure for the purposes of evaluating an investment property’s potential rate of return.
- Fix-and-flip investments: Fix-and-flip homes are typically short-term investments that are purchased and resold within six months. These properties are also unlikely to generate rental income and are, therefore, not good properties to evaluate with cap rate.
- Vacant land: Purchasing land will not yield any rental income, so the cap rate won’t be applicable here. Read our guide on how to buy land if you’re considering this type of purchase.
Other Methods to Evaluate an Investment Property
The cap rate, like other methods of evaluating investments, has limitations and is not applicable in all scenarios. It’s best to evaluate an investment using multiple methods. Below are other tools you can use to determine if an investment is a good deal for you:
- The 1% rule: This states that rental income should be at least one percent of the property’s purchase price.
- The 50% rule: To factor in expenses involved with a rental property, this rule states that you should expect your expenses to be half that of your income. You can then use this figure in estimating things like cash flow and net profit.
- Price to rent ratio: This is calculated by using the median home value in an area and dividing it by the median annual rent. The ratio is intended to give you insight into whether it is cheaper for tenants to be renting or purchasing a home. As a rule of thumb, a ratio of 16 or greater usually means it is better to rent than buy.
- Per-unit price: This is calculated by taking a property’s purchase price and dividing it by the number of units that can be rented in a building.
- Cash flow: Cash flow tells you how much money you should have after all expenses have been considered. Take your rental income and subtract the costs of the rental property, such as loan payments, property taxes, insurance costs, and utilities.
- Gross rental yield: This is calculated by dividing a property’s annual rental income by the total cost of the property. The total cost of the property should include things like the purchase price, closing costs for obtaining a loan, and expenses incurred for renovations or upgrades. A rental yield of 7% or greater is typically considered to be good.
- Return on investment (ROI): You can calculate your ROI by taking your annual return and dividing it by the total cost of the purchase. In general, an ROI greater than 10% is considered desirable.
Unlike the cap rate, many of the methods mentioned above take into consideration your mortgage payments in evaluating an investment property. If you’re purchasing a residential home, you can get a low rate with the providers on our list of the best investment property loans. If you’re looking to obtain commercial property, our guide on the leading CRE rates goes over how rates are determined to help you get the best pricing available.
Bottom Line
Cap rate can be used to compare the risk and potential return on investment for a property. It is best used for properties that consistently generate rental income year-round. Like many other tools used to evaluate investments, it does have its limitations and should be one of several methods you use in evaluating whether an investment is a good deal.
