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The Capitalization Rate Formula is used to calculate the rate at which a company’s stock price has increased. It is often calculated by taking the current share price and dividing it by earnings per share, then multiplying that result with 100. The formula was devised in order of make comparisons easier across companies varying in different market capitalizations more meaningful.
Real estate investors use a capitalization rate, or cap rate, to assess an investment property and indicate its prospective rate of return, which helps them determine whether or not to buy it. The formula for calculating the cap rate is cap rate = net operating income/current property value. Typically, a decent cap rate is more than 4%.
What Is a Cap Rate and How Does It Work?
A cap rate is a metric that investors often use to assess a real estate investment over a one-year period. It should be utilized to evaluate whether or not the property is a good buy. Instead of relying only on the cap rate to decide whether or not to purchase an investment property, we suggest combining it with a few other factors.
Annual returns are used to determine the cap rate. This implies that the cap rate computation takes into account whether a property performed well or badly over the course of a year. It also implies that an investor isn’t receiving a comprehensive picture of the property throughout the years. It’s essential to remember that the cap rate represents the rate of return over a single year, therefore if the property has had previous years of bad performance, the cap rate may be misleading since it only displays one year of good results. It’s simply something to think about as you continue to research the investment property.
Long-term investors who are buying a residential or commercial rental property often utilize the cap rate. It is not used by fx and flippers since they do not plan to rent out the property. Cap rates for comparable properties in the same asset class should be compared.
The capitalization rate is the proportion of net operating income to the value of the property. Your mortgage payments and other expenses connected with buying the home, such as lender fees and closing charges, are not included in the cap rate. That’s why, in addition to the cap rate, you should consider the investment property’s entire financial picture, such as its return on investment (ROI), cash flow, and what similar properties are selling and renting for.
The Importance of a Cap Rate
A cap rate is a useful tool for real estate investors because it allows them to assess properties based on their current value and net operating income (NOI). It provides them with a first-year return on an investment property. An investor may observe an increase in income compared to the price of a property by looking at the cap rate. A decrease in the cap rate, on the other hand, usually implies that the rental revenue is lower than the property’s price. They may use the cap rate to determine whether or not the property is worth purchasing.
When Should You Use a Cap Rate?
The cap rate should be used to assess a real estate investment. It’s most often utilized before buying a home, but it may also be used after you’ve purchased a home and before you put it on the market to sell it.
The capitalization rate is a technique that investors should use in conjunction with other metrics to assist them to assess a property. A buy-and-hold investor, as well as landlords and commercial investors, will often utilize the cap rate. On presently leased residential and commercial buildings, using the cap rate makes sense.
The cap rate may be used for a variety of purposes, including:
When the Cap Rate Shouldn’t Be Used
There are many situations in which the cap rate formula is applicable. Using the capitalization rate, on the other hand, isn’t always a good idea. If you’re purchasing a fix-and-flip or an empty home, you shouldn’t utilize the cap rate.
In most cases, the cap rate should not be used in the following scenarios:
- Fix-and-flip: Investors buy real estate with the aim of rehabbing it and reselling it fast for a profit, thus the capitalization rate isn’t used to evaluate whether or not the property is a suitable investment. They don’t care about the rental revenue since their exit plan is to sell the house rather than rent it out.
- Property acquisition: When assessing land, an investor generally does not utilize the capitalization rate since the land is frequently empty and therefore has no rental revenue, making the NOI impossible to compute. Instead, the investor should carefully study the property, including its existing and permitted zoning, which is critical if the land is to be resold. You should also look at utility accessibility and do a land survey so you know exactly what you’re getting. Read our in-depth guide on how to purchase land for additional information on how to buy and assess the land.
- Purchasing an empty or uninhabited property: Because the cap rate calculation is based on ROI, it should not be utilized if the property is empty because there is no rental revenue to consider. Although some investors utilize anticipated rental revenue, it’s not widely used since it may be incorrect, and estimating expenditures on an empty property can be tricky.
- Buying a vacation rental property: Although a vacation rental property is leased and will generate ROI and operational costs, it skews the capitalization rate formula findings since it isn’t rented all year. Because the owner will use the property as a vacation home for part of the year, a cap rate does not accurately reflect the property’s worth.
- Short-term rental property: A property that provides short-term rentals, such as a vacation rental property, skews the cap rate since the rental periods are often for days or weeks, while a cap rate is usually computed yearly.
The formula for calculating the cap rate
Net Operating Income / Current Property Value = Cap Rate
The net operating income divided by the property value is the cap rate formula.
The formula for calculating the cap rate is done on a yearly basis. Keep in mind that investors compute this in a variety of ways. The capitalization rate formula may be computed with or without the occupancy rate, but if you know what that figure is, it will be more accurate.
Let’s start with how to calculate the NOI. Subtracting the operational costs from the gross rental revenue is a straightforward way to calculate this. The next step is to determine the property’s worth. This is not always the same as the property’s purchasing price.
If you want to include the occupancy rate in your cap rate calculation, you’ll need to multiply the gross rental revenue by the occupancy rate, then deduct your operational costs.
Examples of Cap Rate Calculation
We’ll look at a few instances of cap rate formulas. Let’s start by comparing the cap rates of two multifamily buildings. Remember to compare properties in the same asset type, such as multifamily and commercial buildings, if you want an exact cap rate comparison. Rural, suburban, or urban properties should all be in the same location.
Let’s pretend we’re looking at two multifamily homes in a city. Property A has six apartments, whereas Property B contains eight.
An aspect of the property $850.000 is the estimated worth of the property. 98 percent of the rooms are occupied. $96,000 in gross rental revenue $38,000 in operating costs
B-Property $700,000 is the estimated worth of the property. 98 percent of the rooms are occupied. $72,000 in gross rental revenue $22,000 in operating costs
To begin, multiply the occupancy rate by the total rental revenue as follows:
Property A: 98 percent multiplied by $96,000 is $94,080. Property B: $72,000 x 98 percent Equals $70,560
Subtract the operational costs next:
Property A: $56,080 ($94,080 – $38,000) Property B: $48,560 ($70,560 – $22,000)
Divide the NOI by the property value to obtain the cap rate:
0.066 = $56,080 / $850,000 = Property A 0.069 = $48,560 / $700,000 = Property B
Multiply by 100 since the cap rate formula is given as a percentage:
Property A has a cap rate of 6.6 percent (0.066 x 100). Property B: 6.9% cap rate (0.069 x 100).
Both properties have relatively comparable cap rates, as shown in this example, and Property B is considerably less costly than Property A. Property B would typically be chosen by an investor when comparing properties based on sales price and cap rate.
Let’s look at two additional cap rate formula examples, one with and one without the occupancy rate:
- $500,000 in property value 90% of the rooms are occupied. $60,000 in gross rental income $20,000 in operating costs
To begin, multiply the occupancy rate by the total rental revenue as follows:
$60,000 divided by 90% is $54,000.
Subtract the operational costs next:
$54,000 minus $20,000 is $34,000.
Now you have the net operating income (NOI), which is $34,000. Divide the NOI by the property value to get the following result:
0.068 = $34,000 / $500,000
Because the capitalization rate is usually stated as a percentage, multiply 0.068 by 100:
0.068 multiplied by 100 is 6.8%
This translates to a cap rate of 6.8%.
2. Now we’ll utilize the identical data as before, but without the occupancy rate, to observe how our results vary. We know our gross rental revenue is $60,000 and our operating costs are $20,000, therefore we deduct the operating expense from the gross rental income as follows:
$60,000 minus $20,000 equals $40,000
The NOI is $40,000. The NOI is then divided by the property value:
$40,000 divided by $500,000 is 0.08.
The fraction is then multiplied by 100:
8 percent cap rate = 0.08 x 100
As you can see from the examples above, not using the occupancy rate results in a higher cap rate since it implies the property is occupied 100% of the time, which is seldom the case. Because it takes into consideration when the property is unoccupied, the cap rate from the first example will be more accurate.
Let’s put the cap rate calculation to the test in a new situation. Let’s pretend we already own an income-producing property and we know the NOI and cap rate, but we’re not sure how much it’s worth. We can solve this problem by working backward. You would divide the NOI by the cap rate to get the current property value.
You know, for example, that the NOI is $20,000 and the cap rate is 10%. The property value would then be:
$20,000 divided by 10% is $200,000
What Is an Appropriate Cap Rate?
In general, a cap rate of 4% to 10% is regarded as excellent. However, demand, available inventory in the region, and the particular kind of property all have a role. What constitutes a good cap rate is subjective, and different real estate investors with different investment strategies may see it differently.
For example, in high-demand regions such as in and around major urban areas and high-cost places like Southern California and New York City, a 4% cap rate may be the standard. A lower-demand region, such as a rural community or an up-and-coming district that is undergoing gentrification, may see a cap rate of 10% or higher.
Buyers often want a high cap rate, which means the purchase price is cheap in proportion to the NOI. A larger cap rate, on the other hand, usually indicates more danger, whereas a lower cap rate indicates lesser risk. A property with a high cap rate may be in an area where there isn’t much room for rent increases or where property appreciation isn’t comparable to other regions. An investor must evaluate the risks and choose a cap rate that is suitable for their investment objectives.
A property with a high cap rate may not take into consideration the occupancy rate may utilize anticipated rentals rather than actual rates, or may be located in an area where investment assets are in short supply. A property with a low cap rate, on the other hand, might be in an expensive location near downtown, making it more attractive and creating greater demand for that kind of property. Keep in mind that you should look into how the cap rate was calculated to get a complete view of the real estate investment’s financial picture.
When determining if a property has a decent cap rate, keep in mind that you should compare apples to apples. This implies that cap rates for comparable properties in similar regions should be compared. A cap rate for a multifamily investment property is often considerably lower than for a commercial building with retail tenants. As a result, a multifamily property is a lower-risk, lower-reward investment. This is because people always need a place to live, and retail renters are less likely to pay than multifamily tenants if the economy tanks.
“The concept of “good” and “bad” cap rates is in the mind of the beholder – the higher the cap rate, the greater the risk.” We’re seeing cap rates between 5% and 6% in our target markets and asset class, which, when leveraged prudently, may provide cash-on-cash returns of 8% to 9%.”
— Andrew Campbell, Wildhorn Capital’s Co-Founder and Managing Partner
Cap Rate Influencing Factors
Various investors have different perspectives on what constitutes a good or poor cap rate. Cap rates differ across residential and commercial real estate categories and kinds. However, there are a few variables that influence the cap rate, such as the location of the property and the demand in the region.
The following are some of the most common factors that influence cap rate:
- Location: The location of a property affects demand and the local economy; usually, a more attractive location implies a higher fair market value and higher rents, thus the cap rate stays the same.
- Asset class: This is the kind of property such as multifamily, apartment building, industrial, or commercial property. Residential buildings generally have lower cap rates than commercial properties since commercial properties tend to have higher rents.
- Available inventory: Generally, the smaller the inventory, the greater the demand, which leads to lower cap rates.
- Interest rates: Higher rates usually result in a drop in property prices; when rates increase, loans grow, reducing net cash flow; as a result, rising rates may result in reduced cap rates.
“Since the Great Recession, cap rates have been compressed since U.S. Treasuries have stayed stable and the interest rate environment has remained low.” As the Federal Reserve works toward gradually raising rates, the inverse connection between cap rates and interest rates will begin to emerge.”
— Lucas Fryman, Interra Realty’s Director
Term Definitions for Cap Rate
To comprehend what a cap rate is and how it works, you must first comprehend a few important concepts. These phrases will assist you in determining the cap rate calculation, comprehending the importance of a cap rate, and evaluating the property.
When discussing cap rate, the following phrases are often used:
- Before any costs are removed, gross rental revenue is the entire amount received in rent and any associated rental property income; it may include rent for parking and other variables.
- After subtracting all operating costs, net operating income (NOI) is the yearly revenue produced by an income-producing property.
- Property taxes, rental property insurance, management fees, repairs, upkeep, and other costs such as accounting and legal fees are all examples of operating expenses.
- The ratio of leased space to total available space is known as the occupancy rate, and it is often employed in multi-unit buildings.
Additional Approaches to Investing in Real Estate
Aside from utilizing the cap rate calculation, there are many additional methods for evaluating an investment property. When assessing investment property, we suggest utilizing two to three techniques. This provides you with a more complete picture of the property and if it has the potential to be a profitable investment. You may wish to utilize an extra assessment tool if the property isn’t leased, has to be rehabbed, or you don’t know the market rentals.
Other methods for evaluating investment property include:
- Comparable homes: See what other comparable properties have sold and leased for in the last three to six months; comparables should be similar in kind, amenities, and size.
- Per-unit price: This compares the cost of an investment property per unit.
- Check to see whether the anticipated monthly rent will cover your expenses, such as your mortgage payment, taxes, insurance, utilities, and homeowners’ association fees, to determine the property’s prospective cash flow.
- Divide the yearly rent received by the entire property cost and multiply by 100 to get the gross rental yield; the total property cost includes the purchase price, closing fees, and any remodeling expenditures.
- The 1% rule: The gross monthly income should be at least 1% of the purchase price; other investors use the 2% rule, depending on the property type and location; if the gross monthly income is at least 1% of the purchase price, the property is generally cash flow positive.
- Return on investment (ROI): A good ROI for a real estate investment is typically 10% or higher; you can calculate your ROI on an investment property by dividing your annual return by your total cash investment; you calculate your annual return by subtracting your expenses from your total rental income.
Frequently Asked Questions (FAQs)
What Is the Definition of a Cap Rate?
The cap rate is a rate used to assist investors in determining the value of a real estate investment. It’s a formula that calculates a property’s prospective rate of return. The cap rate formula is simply the NOI divided by the property’s current market value, and the result is a percentage.
What Is a Cap Rate Calculator and How Does It Work?
A cap rate calculator is a tool that may be used to calculate the rate of return on a real estate investment. Property valuation, gross yearly rental revenue, operational costs, and vacancy rate are among the inputs. The cap rate calculator will produce your capitalization rate once the investor fills in the information.
What Is Cap Rate Real Estate, and How Does It Work?
The capitalization rate is most frequently employed in real estate and is referred to as cap rate real estate. It may be used to assess commercial and residential properties, such as duplexes, triplexes, and apartment complexes. In real estate, a cap rate is usually used by investors to assist them to assess a property and its prospective rate of return.
Do you want your cap rate to be higher or lower?
When buying a real estate investment property, investors want a higher cap rate since it indicates that the property’s worth or purchase price is cheap in contrast to the NOI. A seller, on the other hand, may prefer a lower cap rate since it indicates a higher sales price.
Final Thoughts
A cap rate is a technique used by investors to assist them to assess a piece of real estate based on the NOI and current fair market value. The cap rate formula is used to calculate a real estate investment’s prospective rate of return. A decent cap rate in real estate varies, but it is usually between 4% and 10% or more.
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