Cap Rate: Defined And Explained
Victoria Araj5-minute read
November 23, 2022
Rocket Mortgage® doesn't offer commercial real estate loans at this time.
If you’re a real estate investor, or are thinking about becoming one, you’re probably obsessed with finding good deals on investment properties you can flip or rent. When you know a market well, it might 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 one metric that's very important to real estate investors, who use it to help evaluate properties and find good deals. You can use the cap rate to help you 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 rates are measures used to estimate and compare the rates of return on multiple commercial or residential real estate properties. In this article, we’re focusing on residential rental real estate – homes with one to four units – held for commercial, or investment, purposes.
Cap rates are calculated by dividing the property’s net operating income (NOI) by its property asset value.
Cap rates can provide valuable insight into a property. But the cap rate is not the only metric used to evaluate a real estate investment. Investors will also want to consider the return on investment (ROI), internal rate of return (IRR) and gross rent multiplier (GRM), as well as a variety of other factors, including the property’s individual characteristics and location.
Cap Rate Formula: How To Calculate Cap Rates
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.
In order to effectively use this metric, you’ll need to learn how to calculate the cap rate. The formula you’ll need to calculate the cap rate is:
Cap Rate = Net Operating Income (NOI) ∕ Current market value
Let’s walk through an example of this to illuminate 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 the property’s income streams minus the sum of the property’s expenses.
In order to add up the property’s income streams, you can include any form of income it can produce, such as rental income, fees, and onsite amenities that require additional fees. For example, let’s say you’re considering a property that brings in $5,000 per month in rental income without any additional income streams available.
Next, you’ll 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 also 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 are considering, the total expenses are $1,000 per month which includes a 10% vacancy expectation.
If you’re qualifying with rental income in order to buy the property, Rocket Mortgage may assume a vacancy rate of up to 25%.
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 the current market value or purchase price should be used, the majority of investors work with the current market value of the property.
With that in mind, we will 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.
In our example, the current market value of the property is $480,000. With that, we can divide $48,000, which equals 0.10.
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.
Factors That Impact Cap Rates
You use the cap rate to influence your investment decision. But it’s important to realize that there are many factors that can impact the cap rate. A few to consider include market, location, and property type.
Here are a few of the factors that can have a noticeable impact on cap rates:
- Location: As with all things in real estate, the location of the property can have a big impact on cap rates. A riskier location will often accompany a higher cap rate.
- Market size: A large competitive market may have lower cap rates than a smaller market where there is more risk involved.
- Asset stability: The projected stability of the property value can come into play.
- Potential for growth: A property with a lot of potential in a growing market could see an affected cap rate.
- Capital liquidity: The amount of capital you put into the property will have a big impact on the cap rate because that will directly impact your NOI.
Of course, these aren’t the only factors that can affect cap rates. But these could make the biggest impact.
When And When Not To Use Cap Rates
Cap rates are typically used by real estate investors comparing the risk involved in buying multiple commercial properties. Although you can use cap rates to inform other real estate investment decisions, it may not be as helpful.
If you are considering the cap rate as a way to evaluate potential properties, don’t forget that there are many tools to help you. You can use other metrics 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 there is no cap rate number that will be “good” for every property. Instead, the cap rate can be used by investors to determine if a property meets their individual comfort levels.
As a general rule, the formula will determine a higher cap rate for properties that have a higher net operating income and lower valuation. On the flip side of the coin, 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 timeframe 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 Your 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. You can also give one of our Home Loan Experts a call at (833) 326-6018 today.
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