What is a CAP rate?
Capitalization rate is one of the more common ways for real estate investors to determine the value and potential return on an investment property. While determining a cap rate isn’t the only way to evaluate an investment property, it is considered one of the most important metrics for investors to know.
The rate also indicates the amount of time it takes to recover an investment in a property. For example, if a property comes with a 10% cap, it will take 10 years for the investor to recover his investment (called “fully capitalized”).
Although it’s an important metric in comparing investment opportunities, investors should never base a purchase on the cap rate of a property alone. It is useful to note that different cap rates represent different levels of risk – a low cap rate implies lower risk while a high cap rate implies higher risk. Therefore, there is no “optimal” cap rate – it depends on the investor’s risk preference.
For example, consider two properties in different geographical locations – one is in a highly coveted suburban region while the other is in a run-down part of the city. The property in the highly coveted suburban region would show a lower cap through the high market value of the asset. On the contrary, the property located in the run-down part of the city would come with a higher cap, reflected by the lower market value of that asset.
When to Use Cap Rate
A cap rate should be used to evaluate a buy-and-hold investment property, prior to purchasing. It can also be used if you own an investment property and plan to sell it. Before putting it on the market, you should determine your property’s cap rate.
Cap rate can be used for the following types of real estate:
- Single-family investment properties
- Condo and townhome rental properties
- Commercial real estate
- Multifamily rental properties
- Apartment buildings
- Landlords who wish to evaluate a property they own
When Not to Use Cap Rate
There may be times when using a cap rate doesn’t make sense when looking at investment properties. Generally, a cap rate should not be used for the following:
- Fix and Flip: Investors using this strategy don’t care about potential rental income because they are going to sell the property instead of renting it out.
- Purchasing Land: Because it’s impossible to determine the NOI on a vacant piece of land, cap rates are essentially useless.
- Purchasing Vacant Property: Just like buying land, cap rate is dependent on NOI, so it will be difficult to come up with an accurate number for projected rental income. It can also be hard to accurately estimate operating expenses on a vacant property.
- Purchasing a Vacation Rental Property: Cap rates on a vacation home do not accurately predict the value of a property because it’s not rented out year round.
- Short-Term Rental Property: Because a cap rate is calculated annually, short-term rentals skew the cap rate, similar to a vacation rental.
How to calculate a CAP Rate
Cap rate is calculated by the Net Operating Income or NOI, divided by the purchase price or value of a property.
Cap Rate = NOI / Purchase Price
An accurate purchase price can be determined by looking at recent sale prices of comparable properties in the area.
How to Calculate NOI
Net Operating Income is income generated annually from an investment property, minus the expenses associated.
Gross Rental Income – Vacancy, Property Taxes, Property Insurance, Maintenance/Repairs, Utilities, Other Expenses = NOI
After NOI and purchase price have been calculated, the cap rate can then be applied to the property you’re considering buying to show its current market value, based on income. The cap rate will also help the buyer decide if the asking price on the property is reasonable.
If you aren’t sure what your expenses are, then it’s usually safe to assume to use 1 month rent for maintenance and another 1 month rent for vacancy. This assumes the tenant pays utilities which is the most common. It also does not consider the property taxes in this method. To make it easy, only use 10 months of rental income for your calculations then minus out property taxes, landlord paid utilities and any other expenses the landlord must pay.
Using Cap Rate to Compare Properties
If you’re looking at two properties that are alike, but one costs more, it may be because it is generating more income or has lower expenses. The cap rate will break down why one property may be more profitable than a similar property.
Cap Rate Focuses on the Property, Not Financing
The cap rate formula does NOT include mortgage expenses. This is another reason it’s so useful because it excludes the debt and focuses on the property alone. Cap rate assumes the property is bought with cash.
By assuming a property is being purchased with cash, cap rate allows investors to focus on the property’s financials and not the debt.
What is a Good Cap Rate?
Determining what is a good cap rate can be difficult because it depends on demand, available inventory in the area you’re looking and the property type. However, generally speaking, a cap rate between 4 percent and 10 percent is fairly typical and considered to be a good cap rate.
A good or bad cap rate can be very subjective to various investors, depending on their individual investing strategies.
For instance, a cap rate around 5 percent may be the average in higher-demand areas, such as large metropolitan, high cost areas. On the other hand, an up-and-coming neighborhood, with lower-demand, on the outskirts of town, may produce a cap rate upwards of 10 percent.
Buyers usually want a high cap rate, or the purchase price is low compared to the NOI. But, as stated above, a higher cap rate usually means higher risk and a lower cap rate usually means lower risk.
It will be extremely important for real estate investors to see which factors were used to calculate the cap rate to fully understand the financial outlook of the potential investment.
When deciding a good cap rate, make sure you are comparing the same property types in similar areas. It won’t make sense to compare cap rates between a single-family home and a commercial building.
How to determine what the CAP rate average is in my area?
Look at the WFRMLS and see what similar investment properties are capping at and actually selling.
If you need an idea on what a home would rent for, look at KSL.com or Rentler.com and find similar homes and the asking rent prices. Be sure to use comparable with similar bedrooms, area, year built, condition.