What we’ll cover today:
- What is cap rate?
- How to calculate cap rate?
- What is a good cap rate?
- What is the best cap rate?
Cap rate is short for capitalization rate. It is a key metric to help you decide to pursue a property or not. You’ll see cap rates used in todays REIT’s and large investment portfolios. You’ll also see cap rate used in the smallest portfolios. It’s so important it’s mentioned in the sale of almost every rental property. “What is a good cap rate?” and “What’s the best cap rate?” are some of the questions I’m asked all the time when it comes to rental property. Since it’s used all the time in real estate you better know what a cap rate really is.
What Is Cap Rate?
When you hear the words “cap rate” you might conjure up in your head something like the above image. Literally rating a cap to give you a cap rate or rating. Thinking of a cap rate in this way makes sense in our rate-everything-even-if-I-don’t-know-what-I’m-talking-about world. But in reality cap rate is simply one of the easiest ways to figure out if a real estate investment is worth investing in.
A cap rate is simply an equation (oh no, math!) that tells a real estate investor if they will make the money they desire on a given property. Don’t think of this as exact math, just in the ballpark. You won’t know for sure what your cap rate is until you own the property for a period of time.
Think of cap rates like a stock market prediction, but less volatile. Since cap rates aren’t 100% accurate, they will be more of an estimate. We are measuring the cap rate to find the potential return on a given property.
Since realtors and brokers love to exaggerate cap rates, this measurement alone is not enough. It takes more than a cap rate to know if a property is a good deal, but knowing the cap rate will give you a good starting point.
What Is A Good Cap Rate For Rental Property
Some say a good cap rate in the ballpark of about 4 percent or higher. But it depends on the area and your situation. If I’m evaluating a property in a high-risk area I’m going to want a higher cap rate to mitigate that risk. However, if I’m looking at a property in a low-risk area with high appreciation I might be ok with a lower cap rate.
In general, a low purchase price property will have a higher cap rate than I higher priced property for a given area. But you should always use a cap rate you are comfortable with that is in line with your goals. As a rule of thumb, you can consider a cap rate between 4% and 10% to be a good cap rate. A higher cap rate can be good too if the risk isn’t too high.
Why Is Cap Rate So Important And When Is Cap Rate Used?
Typically cap rate is used by real estate investors as a decision-making tool on whether or not to buy or make an offer on property. Since cap rate calculates based on income, it won’t work for every real estate investment. Types of real estate that you should not use cap rate on include:
- Raw Land
- Fix and Flip
- Wholesale Deal
Really any other real estate investment where there is little to no income over time do not make a good fit for cap rate, because cap rate uses annual net operation income (NOI). No income, no cap rate.
Properties that make a good fit for cap rate calculation include:
- SFR (Single-Family Rental)
- Income Producing Commercial Real Estate
- Apartment Buildings
How To Calculate Cap Rate: Cap Rate Formula
Cap rate is really a simple calculation. No complex equations here…phew. The cap rate calculation goes as follows:
(Net Operating Income or NOI / Purchase Price) X 100 = Capitalization (Cap) Rate
Calculating cap rate is simple right? In fact, if you don’t want to calculate cap rate yourself there are a bunch of free cap rate calculators online you can check out. The only 2 numbers you’ll need to calculate cap rate is your target property’s net operating income (NOI) and the total cost to buy your subject property.
It’s the same thing with cap rate as with everything in life: Garbage In = Garbage Out. If you don’t get accurate numbers to calculate your cap rate, your cap rate will not be accurate. Make sure your net operating income number is accurate for your accurate cap rate. Here’s some math again…deep breaths…
Actual Annual Revenue – Total Operating Expenses = NOI (Net Operating Income)
Boom, now you can calculate a good cap rate using a good NOI. Tip: Be sure you use actual, not pro-forma numbers to get a property’s current cap rate.
What Is The Difference Between ROI and Cap Rate?
The difference between cap rate and ROI is they have a different purpose when you analyze a potential property. As you can see, cap rate is used to figure the potential return on an investment property or potential ROI. Since cap rate and ROI can actually be the same number it is easy to see how people get confused.
Cap rate is used to compare similar real estate assets as if you paid cash for them. Using cap rate we can see the potential value of a given property and compare that value to a similar property.
Return on investment (ROI) on the other hand tells you what your actual return on invested capital is. Unlike cap rate, this allows you to compare very different properties and even completely different assets to see their relative value.
For example, if I have a property with an asking price of $1,000,000 and NOI of $100,000 that would give me a 10% cap rate. However, this does not tell me what my ROI is necessarily unless I’m paying $1,000,000 cash for it. If instead I put $100,000 down and financed the rest my cap rate is still the same but my return on investment is very different. (Lenders will probably want at least 25% down, so let’s say you got the seller to finance it to make the numbers easy.)
You now calculate your ROI by subtracting the debt service from the $100,000, which would probably be around $60,000 or more and would give you a total NOI of $40,000. Now you take the $40,000 and divide it by $100,000 then times by 100 to equal 40% ROI. Can you see now why it’s so very important to know what your ROI is vs your cap rate? It’s a 40% return instead of a 10%. This is the power of leverage and real estate.
Can Cap Rate Change?
Of course cap rate can change like everything else in life. If you increase or decrease the NOI the cap rate changes accordingly. You can increase the rents by doing renovations and that would cause the cap rate to go up. Conversely, if your expenses go up the cap rate will go down. Also, if you decrease your vacancy your cap rate will go up.
Here’s A Simple Cap Rate Example
Let’s pretend you found a stellar apartment building for $10,000,000. It’s gross income is $1,000,000 and expenses are $400,000. Let’s do the math and discover the cap rate:
- Purchase Price
$10,000,000
- Property Income
$1,000,000
- Property Expenses
$400,000
- NOI
$1,000,000 – $400,000 = $600,000
- Cap Rate
$10,000,000 / $600,000 = 0.06
0.06 X 100 = 7% Cap Rate
As you can see calculating cap rate is not that hard. Just remember to calculate your NOI as accurately as you can by making sure you have all the expenses. If you have inaccurate numbers for your NOI, you cap rate will also be wrong.
What Is The Best Cap Rate?
There really is no “best” cap rate. There is one that works for you and your investment goals and cap rates that are too low to achieve what you want. To complicate matters, a cap rate may be really low for a given property simply because it has not been managed properly or some other reason. If you have the skills and know-how to solve this problem than you may want to acquire this property and improve the cap rate for your benefit.
Cap Rate Summary
As important as a cap rate is, it is relatively simple to calculate if you have accurate information. It will take proper real estate education and training to make sure you get your cap rates right.