Cap rate: Defined and explained

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If you’re a real estate investor or are thinking about becoming one, you’re probably interested in finding good deals on investment properties you can flip or rent. When you know a market well, it may be easy to see that a property is a winner. But as you begin to grow your holdings, you’ll need a more sophisticated system based on metrics.

The capitalization rate (cap rate) is a metric that's very important to real estate investors. They use it to help evaluate properties and find good deals. Let’s take a look at what cap rates are, what they tell you and how to calculate them.

What is a cap rate in real estate?

Cap rate is a measurement used to estimate and compare the rates of return on multiple commercial or residential real estate properties. In this article, we’ll focus on residential rental real estate – specifically one- to four-unit multifamily homes – held for commercial or investment purposes.

Cap rates are calculated by dividing a property’s net operating income (NOI) by its current market value.

Cap rates can provide valuable insight into a property. But the cap rate isn’t the only metric used to evaluate a real estate investment. Investors will also want to consider other factors such as:

• Return on investment (ROI)
• Internal rate of return (IRR)
• Gross rent multiplier (GRM)
• A property’s characteristics and location

Cap rate formula: How to calculate cap rates

The cap rate of a property is determined based on its potential revenue and risk level as compared to other properties. Importantly, the cap rate won’t provide a total return on investment. Instead, it will indicate an estimate of how long it will take to recover your initial investment in a property.

To effectively use this metric, you’ll need to learn how to calculate the cap rate. The formula for cap rate is:

Cap Rate = Net Operating Income (NOI) ? Current Market Value × 100

Let’s walk through an example to better illustrate how to use this formula.

1. Calculate the property’s net operating income

First, you’ll need to learn how to calculate the net operating income (NOI). The NOI is essentially the sum of a property’s income streams minus the sum of the property’s expenses.

Find The Total Income Of The Property

Add up the property’s income streams by including any form of income it can produce, such as rental income, fees and on-site amenities that require additional fees.

For this example, let’s say you’re considering a property that brings in $5,000 per month in rental income without any additional income streams.

Determine The Property’s Total Operating Expenses

Next, add up the property’s expenses. The obvious expenses to include are property taxes, insurance premiums, repairs and legal costs. However, there are less obvious expenses that should be included, such as potential vacancies. Most investors assume an average of 10% vacancy, but you can do some research in your local area to determine an accurate estimate of the property’s expected vacancy rate.

For the property you’re considering, the total expenses are $1,000 per month, which includes a 10% vacancy expectation.

If you qualify with rental income to buy the property, most lenders may assume a vacancy rate of up to 25%.

Subtract Total Expenses From The Total Income

Once you’ve determined the property’s income and expenses, you can subtract the costs from the income. At that point, you’ll determine the NOI. In our case, the net operating income for the property is $4,000 per month or $48,000 per year.

2. Divide by the current market value

The next step is to divide the net operating income by the current market value. Although there is some debate among investors on whether to use the current market value or the purchase price, the majority of investors work with the current market value of the property.

With that in mind, we’ll stick to the more widely accepted formula and divide the net operating income by the current market value. You can find the property’s current market value by checking out the property details and exploring one of the many home valuation estimation tools available or with a comparative market analysis.

In our example, the current market value of the property is $480,000. We can plug the market value into the formula to determine the cap rate.  $48K / $480K = .1.

3. Convert into a percentage

The final step is to convert the product of your division into a percentage. You can do this by multiplying the result by 100.

In our case, we can simply multiply 0.10 by 100 to arrive at a cap rate of 10%. This percentage is how the cap rate is represented.

When should you not use the capitalization rate?

Cap rates are typically used by real estate investors to compare the risk involved in buying commercial properties. Although you can use cap rates to inform other real estate investment decisions, it may not be as helpful.

For example, if an apartment building you're considering hasn’t historically generated a consistent income because it’s used for short-term vacation rentals, you may not be able to use the cap rate formula to predict the value of the investment. In this case, it may be easier to use a cash flow model to estimate the return.

The cap rate formula also assumes you’re paying cash for the property you're buying. If you’re considering a mortgage to finance your investment, the cap rate won’t be the best metric to use. Don’t forget that there are many tools to help you. You can use other formulas to determine risk levels and the potential returns of an investment rental property.

What is a ‘good’ cap rate?

Although it can be tempting to seek out a universally good cap rate, the realities of the market dictate that no cap rate number will be “good” for every property. Instead, the cap rate can be used by investors to determine if a property meets their comfort levels.

As a general rule, the formula will determine a higher cap rate for properties with a higher net operating income and lower valuation. On the flip side, properties with a lower net operating income and higher valuation will have a lower cap rate.

Typically, investors view properties with a lower cap rate as less risky but should expect a longer time frame to recoup their initial investment. As an investor, you should take some time to consider what an acceptable cap rate is for properties in your portfolio. With a number in mind, you can quickly pass on properties that don’t meet your risk tolerance.

The bottom line: Cap rates help you assess profitability

The cap rate formula is an important metric that helps real estate investors compare rental properties and gauge how much money they can expect an investment to yield. It is one mathematical calculation among many that will help you gain insight into a property you’re considering for purchase to expand your real estate portfolio.

Ready to buy that residential rental property you’ve had your eye on? Apply online today and make Rocket Mortgage your source for mortgages on investment properties.