What Is A Good Cap Rate? Calculator & Formula for Real Estate

Few things are more important to new investors than analyzing and breaking down the financial aspects of a potential rental property. Of all the metrics and calculations used by today’s buy-and-hold investors, however, none may be more fundamental to the foundation of a deal than the capitalization rate.

Otherwise known as the cap rate, the capitalization rate helps determine whether or not a deal’s rate of return and potential profitability is worth the initial investment; it is quite literally a calculation that attempts to tell investors if they should invest in a particular opportunity. And trust us, there are plenty of options investors will want to analyze with a cap rate calculator. For example, according to the U.S. Census Bureau, “renter-occupied units made up 30.5 percent of the inventory in the first quarter” of this year.

That said, nobody will teach you how to calculate cap rate for real estate if you don’t ask; you need to be proactive and translate the information you come up with into actionable steps.

Instead of relying on others, we’ve developed this guide to tell you everything you need to know about cap rates, including:

• What Is Cap Rate?
• What Is A Cap Rate Calculator?
• How To Calculate The Cap Rate
• What Are Cap Rates Used For?
• What Is The Cap Rate Formula?
• Cap Rate Formula Example
• What Is A Good Cap Rate?
• Limitations Of The Capitalization Rate
• Cap Rate (FAQ)
• Final Thoughts On Cap Rate Calculators

What Is Cap Rate?

On the surface, a cap rate is one of the best ways for real estate investors to determine whether or not a deal is worth pursuing. Just beneath the surface, however, the capitalization rate is an invaluable metric that can help quantify the expected rate of return on commercial investment properties (not unlike apartment buildings). As a result, the real estate investing community has come to rely on cap rates to analyze deals and compare potential returns before following through with a purchase.

A properly calculated cap rate can estimate a property’s rate of return. However, a cap rate should only complement a comprehensive and detailed analysis of the subject property; it’s not designed to stand alone. If for nothing else, the cap rate is an approximation, not a definitive value. Nevertheless, despite their inherent inefficiencies, cap rates are an invaluable tool for an experienced investor.

What Is A Cap Rate Calculator?

As previously mentioned, a cap rate is a metric, which means it’s used to measure something. For the sake of this guide, it’s measuring a subject property's expected rate of return by making a simple calculation—hence the need for a real estate cap rate calculator.

As its name suggests, a cap rate calculator will help turn relative variables into quantifiable values expressed as a percentage. The percentage resulting from the calculation will give investors an estimated return on investment (ROI).

Ready to start investing in your first property? Join Alex Martinez at his FREE training to learn how to get started with house flipping and wholesaling!

How To Calculate The Cap Rate Of A Property

As important as it is for investors to calculate the cap rate of a subject property, the actual calculation isn’t all that difficult. Any investor capable of multiplying and dividing a few numbers can calculate the cap rate of their next deal. The most challenging part of the calculation is ensuring you are using the correct variables.

To calculate the cap rate, investors need two specific numbers: the property’s net operating income (NOI) and purchase price. The purchase price is simple to gather; it’s the amount the investor expects to pay to buy the house. On the other hand, the net operating income requires its own calculation. To calculate the NOI, estimate the property’s annual income and subtract the total operating expenses it would take to achieve said revenue.

To calculate the cap rate, divide the net operating income by the purchase price (the home’s current market value). Next, multiply the number you are left with by 100. The resulting number is the cap rate, expressed as a percentage.

What Are Capitalization Rates Used For?

Cap rates are most commonly used for estimating the returns on investment properties. Upon a closer look, however, the metric is more versatile than most people give it credit for. In addition to estimating returns, cap rates may be used in the following ways:

• Reverse Engineer Valuations: Investors may calculate the cap rate if they have the NOI and the value of the property. However, what if the market value isn’t available? If investors can access the cap rate and the NOI, they can estimate a property’s valuation with a similar calculation (NOI/cap rate = property value estimate).
• Compare Similar Properties: If investors are torn between similar investments, the cap rate can help determine which of the real estate comps to choose. Pitting two properties’ cap rates against each other will reveal which investment will likely produce more returns relative to its purchase price.
• Assess Risk: Calculating cap rate metrics can give investors a better idea of the risk associated with the property. All else being equal, a property that returns less capital relative to its purchase price is riskier than a property that returns more. Therefore, comparing the cap rates of two similar subject properties can tell investors which represents the more significant risk.
• Loan Approvals: If lenders know the subject property being purchased is for investment purposes, they may use the cap rate to evaluate a borrower’s risk profile. Anything a lender can use to assess the risk of a loan will ultimately change the underwriting, which can impact the terms of the impending loan.

Read Also: How To Calculate ROI On Rental Property

What Is The Cap Rate Formula?

The cap rate formula divides the net operating income by the home's market value. Then, to express the solution as a percentage, it’s multiplied by 100. For better visualization, here’s what the cap rate formula looks like:

(Net Operating Income / Current Market Value) X 100 = Capitalization Rate

Cap Rate Formula Example

Let’s say, for example, you are considering purchasing a multifamily rental property for $750,000 but don’t want to follow through with a purchase until you have a better idea of the expected cash flow.

In this cap rate formula example, you must gather the purchase price and net operating income. We already know the purchase price is $750,000. That means you need to calculate the net active income. To do so, determine how much the property will bring in each year in rent (not monthly rent) and subtract the costs of keeping the property in operation, like property management fees and maintenance costs.

For this cap rate formula example, let’s say the net operating income is $50,000 per year. Now that we have all the variables, the next step is dividing the NOI ($50,000) by the purchase price/current market value ($750,000):

$50,000 ÷ $750,000 = 0.0667

The answer you get is 0.0667. However, to express the answer as a percentage of return, you’ll need to multiply the answer by 100:

($50,000 ÷ $750,000) × 100 = 6.67%

This brings our final solution to 6.67%. In this example, you can expect a 6.67% return on your investment.

What Is A Good Cap Rate?

A “good” cap rate tends to rest somewhere in the neighborhood of 5.0%. However, before you get caught up in aiming for 5.0% on every investment, it’s important to note that not all cap rates are created equal. More importantly, not all investors view returns and risk the same. Therefore, it’s important to underscore the difference between a good cap rate and a safe cap rate.

Investors looking to cover the purchase cost sooner rather than later should look for a cap rate on the higher end of the “good” spectrum, which may be closer to 10.0%. Investors who prioritize safety, however, will want a lower cap rate, perhaps around 4.0%.

What Is A Good Cap Rate For A Rental Property?

No cap rate is universally good for all rental properties. If for nothing else, different investors have different expectations. One investor thinks a good cap rate for a rental property, and another thinks it's abysmal. A good cap rate rests between 5.0% and 10.0%.

Looking at it from another perspective, a lower cap rate suggests a higher purchase price relative to the income generated. In other words, the cap rate implies potentially safer and lower returns. Conversely, a higher cap rate suggests a lower purchase price relative to income, potentially indicating better returns and slightly more risk.

What Is A Good Return On Commercial Property?

A “good” annual return on commercial real estate can range from 5.0% to 10.0%. However, as previously mentioned, “good” is a relative term. Some investors may be comfortable going outside the “good” range, whereas others won’t consider a commercial investment that returns anything less than 5.0% or more than 10.0%. The real deciding factor of whether or not a cap rate is good is if you are comfortable with it.

Start analyzing properties and investing in real estate like a pro! Join Alex Martinez at his FREE training to learn how to get started with house flipping and wholesaling.

Limitations Of The Capitalization Rate

While a capitalization rate calculator can give investors a good idea of a property’s expected rate of return, the formula isn’t perfect. As a result, investors should never use the cap rate alone; it has several limitations that need to be accounted for, not the least of which include the following:

• Doesn’t Account For Financing: A cap rate calculator for real estate deals only accounts for the relationship between an asset’s income and market value. Therefore, anyone who finances the purchase with a loan will have added costs (like interest) that aren’t factored into the cap rate and impact the return on investment.
• Assumes Income Will Remain Unchanged: Every cap rate calculator assumes the income on an investment property will remain the same. However, every investor will tell you that’s just not the case. Whether changes in gross rent rates, expenses, or vacancy rates, cap rates neglect to account for future shifts that can drastically change the rate of return.
• Ignores Changes In Home Values: The cap rate completely ignores that the value of a property can appreciate or depreciate. That means the formula for the same property will differ in the face of appreciation and depreciation, even after just a short period. Commercial real estate values will eventually fluctuate and change the initial cap rate, but none of that is accounted for in the initial calculation.
• Doesn’t Factor In Taxes: While the cap rate will include the property's total market value, it will not factor in future taxes. Property taxes, for example, will eventually be added to the cost of buying and owning the home. Still, the cap rate calculation doesn’t account for the future expense (even though it can impact the property’s rate of return).
• Neglects Location: Different locations have become synonymous with different rates of return, which means the cap rate doesn’t translate equally from one real estate market to the other.

A cap rate is an excellent tool for gaining insight into a subject property’s potential. However, it is crucial to understand that cap rates are extremely limited. Instead of providing a definitive rate of return that investors can bank on, the cap rate is more of a “ballpark” estimate that leaves a lot of important information out. Therefore, additional research and analysis are required to make a well-informed investment decision.

Cap Rate: Frequently Asked Questions (FAQ)

Cap rates are essential to understand, but far too many inexperienced investors find them to be a source of confusion instead of a valuable tool. As a result, we’ve created the following section to shed some light on some of the most frequently asked questions about cap rates.

Does Cap Rate Include Mortgage?

The cap rate does not include monthly mortgage payments. A cap rate calculator leaves out mortgage payments because it doesn’t account for debt-related expenses. Instead of focusing on the means of acquisition, the cap rate focuses on the property relative to its net operating income.

Do Cap Rates Rise With Interest Rates?

Cap rates typically do not rise with interest rates because they do not account for the loan used to acquire the property. According to Steve Gilbert, Director of Applied Modeling and Analytics for J.P. Morgan Investment Banking, “While cap rates and interest rates are loosely correlated, and rapidly rising interest rates would generally imply upward pressure on cap rates, the change in cap rates would typically be mitigated by rent growth prospects, local economic outlook, neighborhood demand/supply balance and other idiosyncratic factors for a specific property or investor.”

What Does A 7.5% Cap Rate Mean?

The cap rate, expressed as a percentage, estimates a property’s annual net income relative to the home’s market value. Therefore, a 7.5% cap rate suggests an investor can expect to make about 7.5% of the home’s purchase price in annual net operating income.

Final Thoughts On Cap Rate Calculators

Understanding cap rates is an integral part of real estate investing. It offers you a quick glance at a property's income potential in relation to its market value. By leveraging a cap rate calculator, you can evaluate property valuations, compare various investment options, and assess the associated risk.

However, while knowing how to calculate capitalization rate is vital, it's equally crucial to recognize its limitations. Cap rates shouldn't be the only metric used to scrutinize a potential deal; such a singular view can be restrictive. It's important to supplement your comprehensive analysis with cap rates to gain a more accurate and holistic understanding of the property at hand.

Venturing into real estate investing can be complex, but you don't have to navigate it alone. The Pro Wholesaler VIP Program by Real Estate Skills offers invaluable insights, guiding you in making informed investment decisions, and enhancing your understanding of integral concepts like cap rates.

To truly unlock your potential as a real estate investor and learn from the experts, join our FREE training today. Empower your real estate journey with knowledge, clarity, and confidence. Your path to success begins here!