With any investment, there are certain metrics you need to follow to understand how your assets are performing. These metrics help you determine if you're meeting your goals or if it is time to sell.
One of the most important metrics for real estate investors is the capitalization rate, commonly referred to as the "cap rate." At its most basic, this metric measures how much money you're making compared to the value of your property. But the cap rate formula used to determine this metric can get a bit more complicated.
In this article, we'll explain what a cap rate is, how to calculate it, and why it is important to know. Additionally, you'll learn what a good cap rate is and what factors can influence it.
What is a cap rate?
The cap rate is the estimated rate of return that an investor could expect to receive on the value of their real estate property. It is expressed as a percentage. It is based on the total value of your property, but it does not factor in your initial investment nor the equity you currently have after factoring in a mortgage.
Whether you are just learning how to invest in real estate or you’re a veteran investor, the capitalization rate is one of the many important metrics used to evaluate properties.
The cap rate can be used to evaluate any type of income-producing rental property. But it is not designed to gauge the value of raw land, tax liens, or fix-and-flip properties because those types of real estate generally do not produce recurring revenue.
Why capitalization rates are important
Because no two rental properties are the same, using the cap rate allows you to evaluate properties in a more apples-to-apples comparison. It can also help when you are considering investing in different neighborhoods or markets.
For example, cap rates allow you to compare the potential of properties in different cities, such as Los Angeles, Chicago, or Atlanta. Cap rates enable you to easily narrow down the areas where you want to invest before doing a more thorough analysis of individual properties.
Cap rates also allow you to compare a variety of real estate investment property types against each other. It can be difficult to compare a single-family residential property against an apartment building or a piece of commercial real estate. Each rental property has different nuances, but using the cap rate offers a standardized view of each property's potential performance.
An investor could also use cap rates when comparing a rental property against other cash flow-producing investments. When an investor is comparing a bond or CD offering a 3% return against a rental property with a historical 8% cap rate, the rental property investment could make more sense.
When refinancing real estate investments, a bank will also use your cap rate and compare it against similar properties. This could help them determine if you are running your business effectively or if the estimated value of your property is appropriate. When a building is valued too low, improvements funded by the loan proceeds might be able to increase rents, the property's value, or both.
Capitalization rate formulas
In order to calculate the cap rate for your rental properties, you have to understand what numbers are involved in the formula. The formula for calculating a property's cap rate is net operating income (NOI) divided by the current market value of the property.
NOI is the income left over after paying all the normal expenses of operating your property each year. To calculate NOI, you'll need to subtract those annual expenses from the annual income. First, add up all of your property's income for the year, such as rental income, late fees, and pet fees. Then, add up all your operating expenses for those 12 months, including:
- Property management fees
- Property taxes
- Repairs and maintenance
However, you need to exclude mortgage payments (both principal and interest), property depreciation, capital improvements, and taxes. Mortgage payments are a financing expense, which is not included in net operating income. The cap rate does not change if you are financing the property or paying cash to buy it.
Cap rate examples
Let's take a look at two properties and calculate their cap rate based on the following details of each rental:
|Property A||Property B|
|Monthly Principal and interest||$450||$0|
|Repairs and maintenance||$750||$1,400|
To get the cap rate of Property A:
- We calculate the NOI of $8,075 by subtracting all the expenses from the $12,000 rental income.
- Then we divide $8,075 by the current property value of $90,000, and the result is 8.97%.
To get the cap rate of Property B's
- We calculate the NOI of $11,900 by subtracting all the expenses from the $18,000 rental income.
- Then we divide $11,900 by the current property value of $140,000, and the result is 8.50%.
You'll notice Property A has a mortgage and Property B does not. The cap rate ignores mortgage balances and the resulting principal and interest payments on those loans. Only the insurance and property taxes that are typically paid by the mortgage company are factored into the cap rate calculation.
Property A has a smaller value ($90,000), rental income ($12,000), and net operating income ($8,075) than Property B. Property B also has no mortgage, which increases its overall cash flow. Because of that, many investors would think Property B is the better option. However, when you calculate the cap rates for both properties, you'll see that Property A provides the higher potential return.
Factors that could change the capitalization rate
A property's cap rate is expressed as being of a certain date because it is based on the building's current market value. It is not a static number, and it is expected to change over time. That’s because rents generally rise with inflation and property values change based on interest rates, the economy, and other local factors.
Every year, as you finalize your building's annual net operating income, your cap rate calculations should change. Rent will change based on your lease terms and if there is any vacancy. Vacancy is the term used to describe when you do not have a tenant in place. The loss of income and expenses to freshen up a property between tenants can be a major hit to your net operating income.
Inflation also affects many of your expenses, such as insurance and maintenance. Property taxes also tend to change based on the value of your building. Maintenance costs can vary widely from year to year depending on the condition of your property and what repairs were necessary.
Property values tend to rise over time, but year-to-year fluctuations in value can go up or down. Single-family homes are typically valued based on recent sale prices in the neighborhood, while the value of apartments and commercial buildings is based on occupancy levels and rental income.
What changes don't affect the cap rate
Cap rate calculations are focused on the value of the building and its net operating income. Other factors do not change the cap rate calculation, such as:
- Changes in tax laws. Tax laws vary by state. Plus, each investor may be in a different tax bracket based on their income levels and other personal circumstances. If tax rates go up or down, this will not affect a property's cap rate.
- Refinancing your building. Refinancing is a popular way to reduce interest rates, change the term of a loan, or pull cash out of a property's equity. This can improve your overall profitability, increase cash flow, or provide extra cash for other investments, but it will not change your cap rate.
- Capital improvements. Capital improvements do not directly affect your cap rate, but they can indirectly change it if you are able to increase rents or the value of your property. However, the actual cash spent on the improvements or the resulting depreciation is not part of the cap rate formula.
What is a good cap rate?
It is generally better to have a higher cap rate because that means you are getting a higher return on the value of your property. But when you think about cap rates, what is considered "high," “low,” or “good” will vary based on a variety of factors.
Location is always number one in real estate investing – where you are in the country, as well as what type of neighborhood you are evaluating. A high-end property in one neighborhood is going to be different from a run-down building in another. For example, high-demand areas like New York and San Francisco might have a 5% cap rate, while up-and-coming neighborhoods or rural areas might have a cap rate of 10% or more.
A cap rate is best used to determine the potential return of individual properties within a particular real estate market. As the saying goes, "all real estate is local." In this case, it means that a "good" cap rate in one market could be considered a low cap rate in another market.
Cap rates often also vary based on the type of property. Residential properties often have a lower cap rate than retail space. Using data from the Q3 2020 CBRE Cap Rate Survey, the cap rate for Denver multi-family suburban properties was 4.25% to 4.50%, while retail cap rates were 5% to 7%. CBRE is a publicly-traded company (NYSE:CBRE) and is the world's largest commercial real estate services and investment firm with more than 100,000 employees. Its cap rate survey provides localized trends across the U.S. for a variety of real estate property types.
While most people who are investing money in rental properties seek to increase the cap rate on their properties, this can be a double-edged sword. When you look at the cap rate formula and break it down, you'll start to see how a high cap rate can potentially be an indicator of a higher risk level.
Here are three ways that a high cap rate can be misleading:
- Above-market rents can be unsustainable. Charging higher than normal rent can be good in the short term, but prices may reset when the lease expires. This would drop your NOI and your cap rate.
- Being too frugal with your operating expenses. Reducing expenses is another way to increase NOI and cap rates. But make sure this frugality isn't creating bigger problems, such as pushing repairs into future years or underinsuring against risks that could cost you a lot.
- Not knowing how much your property is worth. Half of the cap rate equation is the value of your property. When valuations are off, inappropriate buy-or-sell decisions could be made. Speak with a real estate agent specializing in your type of property to receive a "broker's price opinion" (BPO) of your property’s current value.
How to get the info you need to formulate cap rate
Now that you understand what a cap rate means when it comes to how to make money in real estate, you know you need to focus on the cap rates of potential investments. But how do you get the info you need to do the calculation?
For a residential rental property
Ask the seller for their income statement or create your own estimates. Potential monthly rental income is typically available from a real estate agent or websites like Zillow.
Both those sources can also provide the latest property tax numbers. A quick Google search for the county tax assessor's office may also yield the actual property tax bill or the annual rates used to calculate the taxes owed.
Many property managers charge 10% of collected rents. Local insurance agents or an online application will also provide estimates on insurance costs.
The only true unknown is repairs and maintenance, so you'll have to estimate that or ask a trusted property manager what to expect.
For an apartment complex or commercial building
The seller should provide several years' worth of income statements and a current rent roll. You'll be able to analyze those numbers to look for trends. Look for anomalies and quiz the seller on what happened that caused the numbers to spike or dip.
Speak with your real estate agent and property manager to determine if you can increase rents and occupancy to generate more income and a higher NOI. Increasing those numbers will improve your cap rate.
How is capitalization rate calculated?
The cap rate is calculated by dividing a rental property's net operating income by its current market value. The net operating income is all annual revenue minus normal operating expenses, such as insurance, utilities, property management, property taxes, and repairs. However, you need to exclude other expenses, like mortgage principal and interest, depreciation, and income taxes.
Is a higher cap rate better?
Yes, the higher your cap rate, the more net operating income you are earning off your property. However, if real estate values are declining, you could be fooled into thinking your cap rate is improving. That is why most serious real estate investors look at more than just the cap rate for real estate.
Is the cap rate the same as ROI?
No, the cap rate is not the same as return on investment (ROI). While the capitalization rate is based on the property's current market value, ROI is based on the amount you have invested in the property. Many real estate investors use a down payment and a mortgage to purchase a property, so their investment is typically smaller than the property’s current market value.
Real estate investors should know the cap rate when analyzing potential investment opportunities and during annual performance reviews of their real estate assets. This is one of the many real estate metrics that can help you make buy-and-sell decisions for rental properties.
Keep in mind that multiple factors can influence a property’s cap rate, and different cap rates will be considered "good" in different areas, so it is often better to look at trends over time versus a single year. Combining the cap rate with other metrics, such as return on investment (ROI) and cash-on-cash return, can further refine your decision-making process.