Capitalization (or cap) rate is a quick measure of a rental property’s rate of return. It’s generally used for multi-unit properties, although it can also be used with single-family homes.
How is Cap Rate Used?
Cap rate is used by many investors as an initial measure of the viability of a rental property. It’s calculated by dividing net income by the value of the property. Your cap rate tells you what percentage of the property’s value you will likely earn in a year.
In other words, you’ll know how long it will take you to earn the property’s value in rental income. For example, if your cap rate is 10%, it will take you 10 years to earn the property’s value.
The cap rate excludes many other factors and is meant to be a quick way to determine whether to pursue a property.
If the cap rate of a property is 2% but most others in the area are 6%, that likely indicates a property that isn’t going to return enough revenue.
Cap rate is also useful for comparing properties, although it’s only viable within a certain area. A good cap rate in San Francisco will differ greatly from in Atlanta because the markets are different.
However, if you have 2-3 potential properties within a few miles of each other, cap rate can be one of the factors that you use to determine which one to purchase.
How to Calculate Cap Rate
There are three main steps to figuring out a property’s capitalization rate:
1. Calculate your Net Operating Income (NOI)
To determine your NOI, add up all of the income your property generates for you. This would certainly include the rent payment but can also include other forms of income, such as parking space rentals or storage fees.
Next, subtract all your expenses (except your mortgage payments). This includes utilities, taxes, insurance, maintenance, and more.
Subtract your expenses from your NOI, and then calculate the metric on an annual basis.
Your property generates $2,000 per month, with expenses of $400 per month. Multiply $1,600 by 12 to get an annual NOI of $19,200.
2. Calculate the Property’s Value
There are a few good ways to do this:
- Listed Price – If the property’s for sale, the asking price is a place to start. Remember, cap rate doesn’t care how much you paid, but rather what it’s worth.
- Zestimate – Zillow’s price estimate tool has a notorious reputation, but it’s another useful piece of data.
- Comps – If it’s a single-family home, finding comparable sold properties should be easy. If you’re buying a 100-unit apartment complex, that gets much trickier.
- Professional Appraiser – Your lender will require an appraisal later in the process, but it might make sense for you to hire one now for your initial cap rate calculations to compare properties.
3. Divide NOI by the Property’s Value
Let’s take your NOI of $19,200 and assume your property is worth $400,000. Dividing the NOI by the property value gives you a cap rate of 4.8%.
What Does Cap Rate Mean?
After figuring out your cap rate, you’ll end up with a percentage, such as 4.8% in the previous example. That number means that you’re projecting to earn about 4.8% of the property’s value each year.
But what do you do with that number? Is it good or bad?
It’s difficult to give a hard-and-fast rule about this because different areas have different cap rates. However, many experts say that between 5% and 10% is a sweet spot.
In general, a lower cap rate means lower but more stable income. Most consider a larger cap rate to be a higher risk but with greater potential returns.
Also, understand that cap rates are best used as a comparative measure. For example, if every property in the area seems to be around a 5% cap rate, but then you find one at a 6% cap rate. It’s possible you’re looking at a great deal, but many other factors are at play.
Should You Always Chase High Cap Rates?
When a new investor first learns about cap rates, the first thought is to chase properties with the highest cap rates. If one property is 5% and another is 6%, they’ll immediately dismiss the property with the 5% cap rate.
However, there are plenty of reasons why a higher cap rate may actually be a worse investment. Here are a few scenarios:
- The higher cap rate charges the absolute maximum of the rental price, which makes tenants unhappy and likely to move soon.
- The lower cap rate property could potentially have a higher cap rate with a few simple upgrades or even a price hike. This raises the value of the property with little effort on your end.
- The higher cap rate property may have been used as an AirBnB, charging much higher per-day rates than a long-term rental would provide.
While not always the case, higher cap rates are generally considered a bit riskier. Perhaps the property has recently become run-down, but rent hasn’t dropped accordingly. Or maybe vacancy rates are high (such as in a retail strip mall).
Factors Influencing Cap Rate
As an investor, you should understand more than just how to calculate cap rate. You need to understand the various factors that can affect cap rate so that you can make a real decision between properties.
Here are a few of the most common factors that influence cap rate:
- Market Size – Usually, a more competitive market will have lower cap rates. 10 investors looking at the same property will often drive the price up. Smaller markets may have higher cap rates but may also have higher vacancy rates as there are fewer potential tenants.
- Future Growth or Decline – Cap rate is a forward-looking metric. However, it can’t tell you if the neighborhood seems poised for steep growth or is starting to deteriorate. Those types of changes will affect cap rate.
- Location – Purchase prices and rents change drastically based on area. A swanky neighborhood will cost more and charge more than a run-down neighborhood a few blocks away.
- Property Upgrades – If you purchase a property and immediately spend $20k to upgrade it, your cap rate will likely change as the property is now worth more.
Limitations of Using Cap Rate
Cap rate is an imperfect metric, with many scenarios where it can lead you astray.
Investor’s Financing Method
Perhaps the biggest limitation of cap rates is that they don’t take into account your mode of financing and, therefore, can’t predict your actual monthly cash flow.
Let’s use a single-family home for simplicity’s sake.
You find a property that costs $400,000, and you believe you’ll be able to charge $2,500 monthly rent. According to cap rate, that’s a tremendous deal.
However, you put the minimum down possible (usually 20% for an investment property or $80,000). With an interest rate of 6.5%, your monthly mortgage (including insurance and taxes) is likely to be nearly $2,500!
You’d certainly have negative cash flow when considering operating expenses like maintenance and repairs.
Lease Expiration
Cap rates are a popular metric for large buildings as lease terms and vacancies have less of an impact when offset by many units.
If you’re looking at a commercial building with only two tenants, cap rate can be more volatile. For example, if the lease expires in a few months and you know one of the tenants is going to move out, that can hurt you.
On the other hand, if the tenants are both locked into 5-year leases and are paying what appears to be a good rental price, that can mean an extremely low-risk investment for you.
Appreciation (or Depreciation)
Cap rate only takes into account the current value of a property. However, if you know the city is about to build an incredible park right next to a certain unit, your cap rate won’t tell you that.
Or, if the unit is right next to a commercially zoned area and they’re just starting to break ground, that might lower the values and drastically affect your cap rate.
Not an ROI Metric
Cap rate has no idea how much of your capital you’re using, your interest rate with the bank, or what profit-sharing deals you’ve made with partners. It doesn’t measure your tax deductions or investments into upgrades.
Cap rate assumes you’re paying everything with cash and that the property value and NOI won’t change over time. That’s why it’s better to use it when comparing to other properties to find out which one is relatively the best, and use other calculations to determine your actual cash flow and ROI.
