A cap rate, otherwise known as a capitalization rate, is one of the most important fundamental indicators for determining whether a property is worth pursuing. Not surprisingly, cap rates have proven instrumental in building some of today’s most prolific real estate investment portfolios, and there’s no reason it couldn’t help you do the same. In fact, I’d argue that you can’t even build a halfway decent portfolio without asking, “what is a good cap rate?” It’s that important. Therefore, it’s in your best interest to better understand what a cap rate is and how to use it to strengthen your investing efforts.
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What Is Cap Rate?
Cap rate is one of the easiest and most dependable ways to quantify whether or not an investment deal is worth following through with. In its simplest form, a cap rate is nothing more than an equation, one that will identify how much an investor stands to make or lose if they end up buying the property in question. However, it is worth noting that a cap rate won’t provide investors with the exact amount they stand to gain but rather an estimate. As a result, cap rates are no more accurate than stock market predictions; they are subject to an inherent degree of error and should be taken with a grain of salt. I repeat, cap rates are not 100% accurate; they are merely used to estimate one’s potential return on their investment. That said, a properly estimated cap rate is invaluable when supported with due diligence and acute attention to detail.
Cap rates are not intended to act alone and should instead be used in conjunction with other metrics. A cap rate by itself is almost useless. Still, a cap rate with supplemental data and information can significantly mitigate the amount of risk an investor will be exposed to over the course of an investment.
Why Does It Matter For Investors?
Experts from CoinMarketCap suggest that “discerning the cap rate is important for investors because it can be vital in discerning the quality of a potential investment. Cap rates are not a golden rule, or a perfect metric by which an investment decision can be made in isolation, but when combined as a key metric among several formulations and perspectives, it can help investors make the right decisions for their portfolio.”
Therein lies the benefit of learning how to calculate cap rate: the resulting number can mitigate more risk than many investors realize. If you know how much an investment could potentially make, it stands to reason you’ll know whether or not you should pull the trigger on the purchase.
How To Interpret Cap Rate
We’ve established that cap rate is important, but how do we actually use it? It might seem overwhelming at first glance, but using the cap rate to determine the quality of an investment is actually quite simple. First off, we need to establish that a cap rate is calculated as if the property was purchases outright with cash, and not if a loan was used for the property purchase. With that being said, the cap rate is simply the one-year yield that a property will bring in. In other words, this is the rate of return that the property will bring you.
What Is A Good Cap Rate For Rental Property?
A good cap rate hovers around four percent; however, it is important to differentiate between a “good” cap rate and a “safe” cap rate. This is because the formula itself puts net operating income in relation to the initial purchase price. Investors hoping for deals with a lower purchase price may, therefore, want a high cap rate. Following this logic, a cap rate between four and ten percent may be considered a “good” investment. According to Rasti Nikolic, a financial consultant at Loan Advisor, “in general though, 5% to 10% rate is considered good. Property investors use cap rate every time they invest in a property because it gives them an idea about the profitability. If an investor wants to cover the cost of purchase rather quickly s/he would buy a property which has a higher cap rate”.
However, capitalization rates have also become synonymous with a risk evaluation. To determine a “safe” cap rate, you must identify how much risk you are comfortable exposing yourself to. Essentially, a lower cap rate implies lower risk, while a higher cap rate implies higher risk. Investors hoping for a safer option would, therefore, favor properties with lower cap rates. The most important thing to remember is that you should never take on more risk than you are comfortable with, and you should always use cap rate in addition to other calculations.
How To Calculate Cap Rate: Capitalization Rate Formula
(Net Operating Income / Current Market Value) X 100 = Capitalization Rate
For as important as cap rates are, they aren’t as complicated to calculate as you would assume. In fact, learning how to calculate cap rate requires nothing more than basic math skills or a free cap rate calculator. Although, before you start calculating your own cap rate, you’ll need two things:
It is worth pointing out that calculating a property’s market cap is contingent on gathering accurate information. Therefore, you will need to mind due diligence and make certain that you can pinpoint the net operating income. To do so, estimate the rental property’s annual revenue (using rental income) and then subtract the total operating expenses. For more information on how to accurately estimate net operating income, be sure to read this article.
Considering Occupancy Rate
The above formula is great for comparing potential investments, analyzing single-family homes, and getting a quick overview of a deal. However, it assumes a perfect occupancy rate. When it comes time to mind your due diligence or sell a property, it’s a good idea to adjust your net operating income for a less-than-perfect occupancy rate. This step is crucial when analyzing commercial real estate, as perfect occupancy is much harder to achieve than a single-family home. Try the following calculation for net operating income:
(Gross Rental Income x Occupancy Rate) – Operating Expenses = Net Operating Income
This formula will allow you to account for a five to 10 percent loss when determining potential income. Try plugging in an 85 to 95 percent occupancy rate and see how it impacts the NOI. By taking a reduced occupancy into account, you can get a much more realistic cap rate. This is crucial when you are in the final stages of deciding on an investment. These adjustments can provide a clearer picture of the return potential and steer you away from lower margins.
Cap Rate Vs ROI
The main difference between cap rate and ROI is what the two metrics are used for. As I have already alluded to, cap rate estimates the investor’s potential return on investment (ROI). That said, it’s not hard to see why many entrepreneurs confuse the two. The two metrics are very similar; they tell an investor what to expect if they move forward with an investment. It is worth noting, however, that cap rate and ROI serve a different purpose when analyzing a deal.
Return on investment is meant to give investors an objective percentage of how much they can expect to make a deal. For example, ROI is typically expressed as a percentage to estimate the investor’s potential return on their investment. That way, investors can compare the ROIs of two completely different assets. In addition, the return on an investment expressed as a percentage makes it easier to compare two individual assets, whether they are the same. Investors can, therefore, compare the ROI of a three-month rehab with a 30 year buy and hold.
The cap rate, on the other hand, is used to compare similar real estate assets. For example, a cap rate would be perfect for someone to compare returns from two rental properties, but far from ideal for investors who want to compare a rental property to a rehab.
Cap Rate Example
Calculating the cap rate is relatively simple if you have the property’s net operating income (NOI). Remember to calculate NOI, subtract all expenses related to the property, excluding mortgage interest, depreciation, and amortization, from the property’s income. To explain this, let’s use a simple example.
Say you purchase a property for $1,000,000; it grosses $100,000 through rent and has total expenses of $30,000. Your NOI would be $70,000 ($100,000 – $30,000). To calculate cap rate, divide the NOI of $70,000 by the purchase price of $1,000,000 giving you a 7% cap rate. Calculation can be broken down as follows:
Purchase Price
$1,000,000
Property Income
$100,000
Property Expenses
$30,000
NOI
$100,000 – $30,000 = $70,000
Cap Rate
$1,000,000 / $70,000 = 0.07
0.07 X 100 = 7%
When Is Cap Rate Used And Why Is Cap Rate So Important?
Cap rate is used by investors deciding whether or not to move forward with a given property. In some cases, it may also be used by investors preparing to sell a property. Cap rate works best for rental properties and may not be as helpful in other scenarios. For example, investors should avoid relying on cap rate when evaluating raw land, fix and flip properties, and, in some cases, short term rentals. This is because the cap rate formula relies on annual net operating income, which would not be applicable. Investors (or even landlords) can, however, use cap rate when evaluating several property types, including:
Cap rate is important because it can provide a look at the initial yield of an investment property. The formula puts net operating income in relation to the investment’s purchase price, which can put the potential profitability of the deal in perspective for investors. According to Investopedia, the cap rate can also reveal the number of years it will take to recover the initial investment. For example, a property with a 4 percent cap rate will take four years to recover the investment. Overall, cap rate is an important way for investors to estimate the level of risk associated with a given property.
Can Cap Rate Change?
Cap rate can change as long as investors understand how to boost the NOI. This process is sometimes referred to as compressing cap rates. It involves purchasing a property for below market value and renovating it to boost the overall NOI (typically by increasing the rental income). Renovations can also raise the property value — especially in the right market conditions. The property, which would then have a lower cap rate, could be held or sold for a profit. Remember, as an investor, you have a lot of control over the performance of a given property. With the right planning and execution, you can change the cap rate and boost your portfolio in the process.
Appreciation And Gentrification
Appreciation is the process of an asset increasing in value over time. This trend is part of what makes real estate such an attractive investment. However, while real estate tends to appreciate in value the exact rate can be hard to predict. Instead, investors need to look at other signs the market is growing such as new businesses, and increase in residents, and more.
When considering cap rate and appreciation together, investors can decide whether a property will be a good investment. Appreciation can be especially useful when two properties have a similar cap rate. By looking at the potential appreciation value, investors can decide on the property with more future potential.
The Gordon Model For Cap Rate
The Gordon Growth Model, also known as the dividend discount model, is another form of cap rate that you should be familiar with. It is used to calculate the inherent value of a company’s stock price. The formula looks like this:
(Required Rate of Return – Expected Growth Rate) = Expected Cash Flow / Asset Value
In this formula, the expected cash flow equates to the NOI, and asset value represents the property’s market price. This means that the cap rate is simply the difference between the rate of return and the expected growth rate.
What Is Cash Flow?
Cash flow is the income you stand to generate from rental income after monthly expenses are subtracted. To calculate cash flow, estimate your total monthly rent income. Then, subtract monthly costs such as your loan repayment, regular maintenance, and utilities if applicable. The resulting number represents your expected monthly cash flow. This number will not be perfect — after all, rental income can fluctuate with vacancies or unexpected costs. However, it will give you a good idea of potential returns.
What Is Internal Rate Of Return?
Internal rate of return (IRR) is used to measure the profitability of a buy-and-hold investment. The IRR is determined by adding the cash flow and expected property appreciation, and dividing by the expected hold period. The resulting number will illustrate how much investors can expect to gain from renting and ultimately selling an investment property. This formula is helpful for painting a better picture of the overall value, though it does rely on estimates. There is no way to fully predict how much a property will sell for in the future, or how much it will appreciate. For this reason, IRR (like many real estate calculations) should be used alongside other formulas when analyzing a deal.
Summary
An investment property cap rate may sound simple, but its implications are heavily weighted. That’s why it’s crucial to expand your real estate education and ask questions like “what is a good cap rate?” After all, those who equip themselves with the best investing tools—like cap rates—stand a better chance at realizing success in the industry.
What is a good cap rate for real estate, in your opinion? Feel free to let us know your thoughts on good cap rates in the comments below.
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FAQs
To calculate cap rate, follow this formula: (Gross income – expenses = net income) / purchase price * 100. Cap rates between 4% and 12% are generally considered good, but it's important to remember that other factors, such as potential improvements, should also be considered when evaluating a property.
Is a 5% cap rate good? ›
Market analysts say an ideal cap rate is between five and 10 percent; the exact number will depend on the property type and location. In comparison, a cap rate lower than five percent denotes lesser risk but a more extended period to recover an investment.
Is a 4% cap rate good? ›
Investors hoping for deals with a lower purchase price may, therefore, want a high cap rate. Following this logic, a cap rate between four and ten percent may be considered a “good” investment. According to Rasti Nikolic, a financial consultant at Loan Advisor, “in general though, 5% to 10% rate is considered good.
Is 12% a good cap rate? ›
A good cap rate hovers somewhere between 8% and 12%, but the real answer is: It depends. While a 10% cap rate might be solid for some rentals, your percentage is not the only factor in determining whether taking on an Airbnb investment is right for you.
What does 7% cap rate mean? ›
It's basically a mathematical formula used to calculate the ROI (Rate of Return) you'd expect to receive from a property you plan to purchase. Calculation Example: If the current market value of a property is $1 million and has an NOI (Net Operating Income) of $70,000, then the cap rate is 7% or 1,000,000 ÷ 70,000 = 7.
What is the 50% rule in real estate? ›
Like many rules of real estate investing, the 50 percent rule isn't always accurate, but it can be a helpful way to estimate expenses for rental property. To use it, an investor takes the property's gross rent and multiplies it by 50 percent, providing the estimated monthly operating expenses. That sounds easy, right?
What is the 2% rule in real estate? ›
2% Rule. The 2% rule is the same as the 1% rule – it just uses a different number. The 2% rule states that the monthly rent for an investment property should be equal to or no less than 2% of the purchase price. Here's an example of the 2% rule for a home with the purchase price of $150,000: $150,000 x 0.02 = $3,000.
What is a poor cap rate? ›
Generally, a high capitalization rate will indicate a higher level of risk, while a lower capitalization rate indicates lower returns but lower risk. That said, many analysts consider a "good" cap rate to be around 5% to 10%, while a 4% cap rate indicates lower risk but a longer timeline to recoup an investment.
What cap rate is too high? ›
In real estate, a low (less than 5%) cap rate often reflects a lower risk profile, whereas a higher cap rate (greater than 7%) is often considered a riskier investment. Whether an investor deems a cap rate “good” is a direct reflection of whether or not they think the investment's return matches to the perceived risk.
Is it better to buy at a higher cap rate? ›
It varies from investor to investor and property to property. In general, the higher the cap rate, the greater the risk and return. Some elements that affect a property's cap rate are hyper specific.
Generally, a good ROI for rental property is considered to be around 8 to 12% or higher. However, many investors aim for even higher returns. It's important to remember that ROI isn't the only factor to consider while evaluating the profitability of a rental property investment.
What is a typical cap rate? ›
Cap rates are measured as percentages, typically from 3-20%. This risk is measured based on the amount of time it takes for an investor to recover their initial investment. When a cap rate is low, the property has a relatively higher value and lower risk.
What is a good cap rate for multifamily property? ›
That said, a “good” cap rate for multifamily properties is at least 4% but can extend up to 8% to 12%. Regardless of market or property condition, multifamily properties tend to have a lower cap rate than other real estate investments.
Why is a higher cap rate riskier? ›
Overall, the higher the cap rate, the riskier the investment. That is, a high cap rate means your asset price is low, which typically points to a riskier investment. But you must compare to market cap rates in your area, as they can vary significantly. So, proceed with caution.
Why is lower cap rate better? ›
It's generally better to have a lower cap rate than a higher one. A lower cap rate implies that the property is more valuable and less risky due to type, class, and market. While a higher cap rate offers investors a higher return, that property investment typically has a higher risk profile.
Is cap rate the same as ROI? ›
Is Cap Rate Same as ROI? Cap rate and ROI are not the same. The cap rate is the expected return based on the property value, but the ROI is the return on your cash investment, not the market value.
What is the 80% rule in real estate? ›
The 80% rule means that an insurer will only fully cover the cost of damage to a house if the owner has purchased insurance coverage equal to at least 80% of the house's total replacement value.
What is the 4 3 2 1 rule in real estate? ›
THE 4-3-2-1 APPROACH
One simple rule of thumb I tend to adopt is going by the 4-3-2-1 ratios to budgeting. This ratio allocates 40% of your income towards expenses, 30% towards housing, 20% towards savings and investments and 10% towards insurance.
What is the 100 times rule in real estate investing? ›
Savvy real estate investors often pay no more than 100 times the monthly rent to purchase a property. In the case of the couple above, an investor following the 100 times monthly rent rule wouldn't pay more than $750,000 because the monthly market rent was $7,500.
What is the 36 rule in real estate? ›
A household should spend a maximum of 28% of its gross monthly income on total housing expenses according to this rule, and no more than 36% on total debt service. This includes housing and other debt such as car loans and credit cards. Lenders often use this rule to assess whether to extend credit to borrowers.
One popular rule of thumb is the 30% rule, which says to spend around 30% of your gross income on rent.
What are the three most important rules of real estate? ›
The three rules of real estate: location, location, location.
Is 7% a good cap rate? ›
Average cap rates range from 4% to 10%. Generally, the higher the cap rate, the higher the risk. A cap rate above 7% may be perceived as a riskier investment, whereas a cap rate below 5% may be seen as a safer bet. If a property has a 10% cap rate, you should expect to recover your investment in about 10 years.
What makes cap rates go up? ›
Following the laws of supply and demand, cap rate compression may result from high investor demand or a general lack of quality inventory, resulting in higher prices for the same assets. In addition to the market's overall supply and demand, cap rates are also correlated with the debt market.
What is the cap rate for multifamily housing in 2023? ›
In Q1 2023, the average going-in cap rate, which is based on the first year of net operating income at the property purchase price, increased 23 basis points to 4.72%, “marking the first significant quarterly deceleration in cap rate expansion since the Fed began its latest round of rate hikes,” according to CBRE.
What does cap rate 6% mean? ›
Calculating a Cap Rate in Commercial Real Estate
If you invested $1,000,000 in a property, with a 6% CAP rate, you would receive $60,000, at year-end.
Why does value go down when cap rate goes up? ›
The interrelationship of NOI, cap rate and property value means that a property's value can be determined using the NOI and the cap rate — property value equals the NOI divided by the cap rate. A higher cap rate will therefore result in a lower property value, NOI being equal.
What does a 20% cap rate mean? ›
Assuming that the average capitalization rate of the market in which this property is located is 18%. The investor can conclude that a 20% CAP rate means the property is overperforming the market by 2%. Based on the property's market value, the investor is generating 20% of his property's value per year.
Is cap rate based on gross or net income? ›
Cap Rate = Net Operating Income (NOI) / Property Value
For example, if a $1 million investment property is generating $50,000 in annual net operating income (rental fees less operating expenses), the cap rate on the investment is 5.0%.
Does a seller prefer higher or lower cap rates? ›
For example, if you are selling a property, then a lower cap rate is good because it means the value of your property will be higher. On the other hand, if you are buying a property then a higher cap rate is good because it means your initial investment will be lower.
Higher borrowing costs
This is because the higher the cost of borrowing (brought upon by higher interest rates), the smaller the debt an income-generating property can service. This, logically, leads to a fall in property prices which increases cap rates.
Is 7% ROI on rental property good? ›
A good ROI for a rental property is typically more than 10%, but 5%–10% can also be acceptable. But the ROI may be lower in the first year, due to the upfront costs of buying a home. A fixer-upper may offer more upfront savings as their average list price is 25% lower than turnkey homes.
What is the formula for cap rate? ›
To calculate cap rate, follow this formula: (Gross income – expenses = net income) / purchase price * 100. Cap rates between 4% and 12% are generally considered good, but it's important to remember that other factors, such as potential improvements, should also be considered when evaluating a property.
What is a good noi in real estate? ›
A cap rate between 8% and 12% is considered good for a rental property in most areas (ones in expensive cities may go lower).
What does an 8% cap rate mean? ›
Cap rates give investors a glance at the investment opportunity presented by a property. If the investment is offered at a 10% cap, you can expect to yield a 10% return; an 8% cap would yield an 8% return (both assuming you paid cash without financing).
What is a cap rate for dummies? ›
The cap rate of a property is determined based on the potential revenue and the risk level as compared to other properties. Importantly, the cap rate will not provide a total return on investment. Instead, it will indicate an estimate of how long it will take to recover the initial investment in the property.
Do you include mortgage in cap rate? ›
Does a cap rate include mortgage? No, the cap rate calculation does not include your mortgage payments. The formula for calculating cap rate includes your annual net operating income, minus annual expenses other than your mortgage. (Then, you'll divide that number by the home price to get your cap rate.)
What is the cap rate 2% rule? ›
This is a general rule of thumb that determines a base level of rental income a rental property should generate. Following the 2% rule, an investor can expect to realize a gross yield from a rental property if the monthly rent is at least 2% of the purchase price.
What is average cap rate in real estate? ›
In commercial real estate, a capitalization rate (“cap rate”) is a formula used to estimate the potential return an investor will make on a property. The cap rate is expressed as a percentage, usually somewhere between 3% and 20%. Cap rates generally have an inverse relationship to the property value.
What is a good return on multifamily investment? ›
What is a good ROI for multifamily? A good return on investment (ROI) for multifamily investment could be between 14% and 18%. Factors like the local real estate market and asset class will affect this. For example, if you invest in a growth market, your initial ROI will be on the lower end.
Top 8 Cities With the Highest Traditional Cap Rate
- Greenwood, MS: 10.18 %
- Spruce Pine, NC: 9.98%
- Suwannee, FL: 9.97%
- Presidio, TX: 9.79%
- Saxonburg, PA: 9.67%
- Alturas, CA: 9.14%
- Sylacauga, AL: 8.98%
- Waterville Valley, NH: 8.70%
An increase in the value of a property generally results in a lower cap rate, while a decrease results in a higher cap rate. On the other side of the equation, an increase in NOI results in a higher cap rate, while a decrease in NOI results in a lower cap rate.
What does a 9 cap rate mean? ›
Cap rates are seen as a measure of risk and return, a “low” cap rate of 3-5% would mean the asset is lower risk and higher value; a “higher” cap rate of 8-10% reflects a lower price, higher risk and higher return.⁶
How do you value a property with a cap rate? ›
The Capitalization Rate or Cap Rate is a ratio used to estimate the value of income producing properties. Put simply, the cap rate is the net operating income divided by the sales price or value of a property expressed as a percentage.
Does cap rate include taxes? ›
The cap rate calculation focuses on the property and not on the finance type used to obtain the property. As for taxes, property taxes are included because they remain the same. Income taxes are not included since they vary between situations and owners.
Is cap rate the same as 1% rule? ›
The 1% rule is a strategy used in real estate investing to determine your cap rate. It states that when evaluating properties, investors should calculate monthly rent to be at least 1% of the total purchase price.
Are interest rates and cap rates related? ›
The Relationship Between Cap Rates and Interest Rates
Commercial real estate cap rates and interest rates are historically highly correlated and understanding the relationship between the two can give you insights into the market. As interest rates go up and down, cap rates also go up and down.
Are cap rates accurate? ›
Cap rates are not always accurate: Cap rates are a rough estimate of the return on investment, and the accuracy of the cap rate depends on the accuracy of the net operating income and the property's market value.
What does 5 cap rate mean in real estate? ›
The formula for a cap rate is simple: cap rate is the annual NOI divided by the market value of the property. For example, a property worth $10 million generating $500,000 of NOI would have a cap rate of 5%.
Is 6% a good cap? ›
Generally, a high capitalization rate will indicate a higher level of risk, while a lower capitalization rate indicates lower returns but lower risk. That said, many analysts consider a "good" cap rate to be around 5% to 10%, while a 4% cap rate indicates lower risk but a longer timeline to recoup an investment.
In real estate, a low (less than 5%) cap rate often reflects a lower risk profile, whereas a higher cap rate (greater than 7%) is often considered a riskier investment. Whether an investor deems a cap rate “good” is a direct reflection of whether or not they think the investment's return matches to the perceived risk.
Why do sellers want a low cap rate? ›
Why do sellers want a low cap rate? Sellers want to maximize the value of the property they are selling. Because commercial real estate uses cap rates to value properties instead of comparable sales, a low cap rate means they're obtaining a high value for the property they're selling.
What is a realistic cap rate in real estate? ›
Average cap rates range from 4% to 10%. Generally, the higher the cap rate, the higher the risk. A cap rate above 7% may be perceived as a riskier investment, whereas a cap rate below 5% may be seen as a safer bet. If a property has a 10% cap rate, you should expect to recover your investment in about 10 years.
What does 8% cap rate mean in real estate? ›
Cap rates give investors a glance at the investment opportunity presented by a property. If the investment is offered at a 10% cap, you can expect to yield a 10% return; an 8% cap would yield an 8% return (both assuming you paid cash without financing).
What does 8.5% cap rate mean? ›
Cap rates also showcase the relationship between risk and return; a “low” cap rate of 3-5% would mean the asset is lower risk and higher value, while a “higher” cap rate of 8-10% reflects a lower price, meaning higher risk and a higher return.
What is the rule of thumb for 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.
What is a good cap rate for multifamily? ›
Historically, a good cap rate for multifamily is over 4% and could be as high as 10%. That range comes down to the fact that several factors can influence a good cap rate and possibly make a low cap rate look better or a good one look worse than it is. Interest rates are an important factor in assessing cap rates.
Do buyers want a high cap rate? ›
Buyers usually want a high cap rate, or the purchase price is low compared to the NOI. But, as stated above, a higher cap rate usually means higher risk and a lower cap rate usually means lower risk.
Why is smaller cap rate better? ›
A higher cap rate indicates that the expected returns from a property are riskier, and real estate investors will pay less for such property. A lower cap rate represents a less risky property, and an investor will be more willing to pay above the property value to receive a lower yield.
Is it better to have a higher or lower cap rate? ›
What's a good cap rate? It varies from investor to investor and property to property. In general, the higher the cap rate, the greater the risk and return.
This is relative: A "good" market cap will align with your goals for your portfolio. Large-cap companies tend to be more stable and carry less risk than small-cap companies. And while small-cap companies may carry more risk, they can offer big rewards if they experience significant growth.
