Cap Rate (Capitalization Rate) in Real Estate: What is It, How Do You Calculate It, and Why is it Important?
Cap rate (short for “capitalization rate”) is essential for educated real estate investors. It’s one of the most popular formulas for comparing two different investments with various upfront costs and potential returns.
Whether you’re looking at a value-add investment with a real estate private equity group, a REIT, or a single-family rental, knowing this formula will give you an integral data point to figure out which investment vehicle is in line with your expected returns.
That way, you’ll be able to weigh the potential benefits and drawbacks of real estate compared to stocks, mutual funds, bonds, or whatever other investment vehicle you’re interested in.
In this article, we’ll define the cap rate formula, show you how to use it, and answer some commonly asked questions.
First, let’s start with a basic definition.
What is a Cap Rate (Capitalization Rate)?
Put simply, the cap rate is how much income a property is expected to generate after all expenses are covered (also known as net operating income), measured against the property's current market value. Essentially, it’s the annual yield on the investment, and can be similarly compared to a coupon rate on a bond.
Expressed as a formula:
Capitalization Rate = Net Operating Income (NOI) / Current Market Value
Let’s look at what each of those factors mean, exactly.
Net Operating Income
Net operating income is a pre-tax figure that includes all of your income after expenses, excluding mortgage payments and interest. The goal, as we’ve mentioned, is to standardize various investments so you can distinguish their returns.
Calculating the net operating income is probably the most research-intensive part of the process, since you’ll have to crunch the numbers on every expense related to securing and maintaining the property.
Now, market value is seemingly a bit simpler, but there are some caveats to it, as well.
Current Market Value
In real estate parlance, “market value,” is the amount that the average, motivated buyer would pay for the property, based on comparable sales in the area, how much income the property generates, and the cost of construction.
It should be noted, however, that market value is not the same thing as sale price. It’s entirely possible that a well-informed investor is able to secure a property for much less money than its actual market value. Building a new property might cost $400,000 and actually be worth hundreds of thousands of dollars more when it’s on the market. When using this formula, keep that in mind.
All other things being equal, the higher the cap rate, the more attractive the investment on the buy side, and vice versa, the lower the cap rate, the more valuable the property on the sale side. The catch, however, is “all other things being equal.” There are still many other factors you should consider when analyzing investments. Determining how those factors might affect profitability isn’t easy. There’s always a certain level of risk associated with any venture. One formula alone doesn’t capture or measure that risk.
An Example: Calculating A Property’s Cap Rate
For example, let’s say you have two options: one is a multi-family property that costs $750,000 and generates $4,800/month in rent, and the other is a single-family rental that costs $280,000 and generates $2,250/month in rent.
The multi-family property has maintenance costs of $890/month. The single-family rental has maintenance costs of $550/month.
Cap rate is often described as a “back-of-the-napkin” formula. Investors use cap rate so that they don’t have to memorize the above: rent, market value, and maintenance. It’s popular for the same reason that ROI is popular in stock investing. It’s widely used and it makes analysis simpler.
Here’s what the multi-family property looks like when we put in all the numbers, step-by-step:
- First, let’s turn the monthly rent figure into an annual one: $4,800 x 12 months = $57,600.
- Next, we’ll find the net operating income by subtracting maintenance costs from the annual rent: $57,600 - $10,680 (the annualized maintenance costs) = $46,920.
- Finally, we’ll find the cap rate by taking the NOI ($46,920) and dividing it by the cost it took to acquire the property $750,000.
- The result? 0.06256, or 6.256%
Doing the same thing with the other investment yields an after-maintenance yearly income of $20,400, and dividing that by the respective value of the property ($280,000) yields a cap rate of 13.73%.
Going by cap rate alone, we can see that the single-family rental is potentially twice as good of an investment as the multi-family property.
Again, that’s something that we may not have been able to determine at first glance. That’s what the cap rate is good for.
A higher cap rate, however, doesn’t always mean that it’s the better investment for you. That depends on your overall portfolio and risk appetite.
Different Cap Rates Can Indicate Different Levels Of Risk
Typically, high cap-rate properties have less demand, lower growth potential, or higher levels of risk. A high cap rate may look good in terms of income potential, but it sometimes requires more investment and management. For a real-life example, this is what value-add real estate investing is aiming to achieve.
On the other hand, a low cap rate with a property located somewhere up town is, generally, lower risk, more desirable, with a higher rent growth potential. It’s why an investor would be willing to pay a premium to buy a low cap rate investment. Despite its low cap rate, the earning potential is more stable, and the risk less intense. This is typically associated with core and core plus investments.
While these are general guidelines, one of the biggest risks in investing is inaction. Sometimes, you encounter stellar opportunities and shouldn’t write off a potential investment as overly risky just because it has a high cap rate. The two aren’t intrinsically linked.
When you find great opportunities, verified by proper due diligence, it’s best to act quickly. That way, investors enable an accelerated return of original equity investment, a core tenet of our proven strategy. When evaluating an investment, remember that formulas only tell half the story -- and cap rate is a rather simple one.
Depending On Cap Rate Alone Will Not Allow You To Effectively Determine The Value Of Your Investment
As an investor, you should never base your investment choices on cap rates alone. While they’re effective when you’re looking to develop a baseline measure, there are many factors that should go into your decision:
- Property Type
- Property Conditions
At Valiance Capital, we make sure to dive deep into the variables surrounding every property we target, making sure our investors get the best risk-adjusted returns possible.
Is Cap Rate The Same As ROI?
While they may sound the same, ROI and capitalization rates are not the same. The biggest difference is that ROI incorporates other, non-recurring costs and measures total return including any appreciation. Whereas a cap rate measures the performance of the operating cashflows against the investment. It does not take into account any appreciation.
Is a High Cap Rate or a Low Cap Rate Better?
A high cap rate is better, all other things being equal on the buying side. By and large, a high cap rate may suggest that one investment is riskier than the other, but that’s not necessarily true all of the time. A low cap rate is better on the selling side. Your property is more valuable if the cap rate is lower.
What Is a Good Cap Rate?
It depends on risk tolerance and the cost of capital. A good cap rate provides a healthy spread above the average cost of debt. This is called positive leverage.
For example, if the interest rate on debt is approximately 3.00%, A 5.00% cap rate would be a good rate because there’s a healthy 2.00% spread between the two rates. Cap Rates and Interest rates are strongly correlated.
Ultimately, a good real estate investor should find a balance between the cap rate, risk level, growth potential, and other deciding factors. Every property has inherent risks, and a cap rate alone doesn’t necessarily provide a full picture, but it does help compare where market expectations are for comparable investment yields.
Always do your due diligence when analyzing investments.
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