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:
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.
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).
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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.
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:
Read Also: How To Calculate ROI On Rental Property
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
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.
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%.
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.
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.
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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:
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 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.
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.
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.”
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.
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.
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