As a real estate investor, finding profitable properties and gauging whether they’re likely to be an excellent long-term investment is vital to ensuring that you make—and not lose—money on the deal. In addition to in-depth research on a property, the neighborhood, the historical growth in the area, and the future developments that are planned around the property, intelligent real estate investors also rely on several metrics that help give them a decent idea of whether to proceed with an investment or not.
One of the most common measures of a property’s investment potential is the Capitalization Rate. In this article, we’ll talk about what the capitalization rate is, how to calculate it, and when it’s most likely to come in useful.
What is the Capitalization Rate?
Capitalization Rate, or “cap rate” for short, is used in commercial real estate to calculate the rate of return on a real estate investment property. Calculated by dividing the property’s annual Net Operating Income (NOI) by its property value, the Cap Rate is used to estimate an investor’s potential return on investment on that particular purchase. That is, it estimates how long it will take to recover the initial investment on a property.
The Cap Rate is a very popular metric widely used to quickly compare the returns on similar properties when making an investment decision. However, like most other metrics in real estate, the Cap Rate is an indicator of overall trends and is not infallible.
The Cap Rate should be one of several metrics used to evaluate a property and requires due diligence and attention to detail to calculate correctly. Still, when used correctly and in combination with other real estate metrics, the Cap Rate can be an excellent tool for investors to mitigate risk and make wise and informed decisions about potential properties to add to your portfolio.
How to calculate the Cap Rate
Calculating the Cap Rate can be done through a simple formula, but to do so, we need to arrive at a few numbers first. The Cap Rate formula looks like this:
Cap Rate = Net Operating Income / Current Market Value
Here are the steps to calculating a property’s Cap Rate.
1. Calculate the property’s Net Operating Income (NOI)
The Net Operating Income or NOI is the total of a property’s income minus the total of the property’s expenses. Expenses include property taxes, insurance premiums, repairs, property management fees, and marketing or legal costs. These are annual calculations, so you’ll want to take your gross rent and multiply it by 12. Then do the same for your expenses.
There are two important considerations to make when calculating the NOI on a property:
- Rental income: If the property isn’t currently rented, you’ll need to estimate the rent to make your calculation. You don’t want to overestimate since this could make the property appear to be a more valuable investment than it is. Still, you don’t want to underestimate either because you could lose out on a potentially significant investment if the numbers aren’t accurate. Look at the going rate for similar buildings with similar amenities in the same neighborhood and, if the place has been rented before, determine what the going rate was and if it reflected a fair market rate.
- Vacancy rate: It’s easy to forget this vital fact when estimating, but most rental properties will sit empty part of the time. Even with single-family and multifamily homes, you may have vacancies if a family decides not to renew their lease and you’re unable to find new tenants in time. While you don’t want to inflate numbers too much, it’s wise to err on the side of caution with the vacancy rate. Typically, investors assume an average of 10% vacancy, but it’s worth looking at similar properties to arrive at a more realistic number.
Once you’ve factored in all the variables, subtract the property’s annual costs and expenses from the property’s annual income. This is your NOI.
2. Divide the NOI by the property’s asset value
Now you’ll divide the NOI we’ve just calculated by the property’s current asset value. There is some debate about whether the property’s asset value is the current market value or the property’s purchase price. The purchase price is the least preferred number because if the property was last purchased years or decades ago, the purchase price could be meager. Properties can also be inherited, making the sales price zero. Current market conditions tend to be more reflective of a property’s potential and are, therefore, more commonly used.
Since Cap Rate is often expressed as a percentage, once you’ve divided the NOI by the property’s current market value, multiply that number by 100 to arrive at the Cap Rate.
What is a good Cap Rate?
While there is no universal formula for a good Cap Rate, the metric is generally used as a measure of risk. As a rule of thumb, the higher the Cap Rate of a property, the higher its Net Operating Income and the lower its valuation is likely to be. And in reverse, the lower the Cap Rate, the lower the NOI, and the higher the property value. A high Cap Rate is acceptable, even desirable, for some aggressive investors who don’t mind higher risk for a higher reward. This tells us that unless you’re an experienced or aggressive investor, what you’re looking for is not a “good” Cap Rate but a “safe” Cap Rate.
A safe Cap Rate means it’s generally low. Some analysts consider 4-10% a safe Cap Rate, with 4% indicating a lower risk but a more extended period to recoup your investment.
Factors that influence the Cap Rate
It’s important to understand that in addition to the Cap Rate calculation we’ve done, a number of factors can impact and lead to different Cap Rates. These include:
- Location: You’ve heard it said before, but a large part of the profitability in a real estate investment comes down to location. The less risky the location, the lower the cap rate is likely to be.
- Competing properties: How competing properties are doing in the local market will likely impact your Cap Rate. Generally, properties in established real estate markets with high growth rates and more developed infrastructure will have lower cap rates.
- Capital investment: If you’ve invested in a renovation to make a property more attractive to potential tenants and command higher monthly rents, this investment will increase your operating income and directly impact your NOI.
A variation of the Cap Rate is the Gordon Growth Model, sometimes also known as the Dividend Discount Model (DDM) and used in finance to value a stock with dividend growth. This model is used by investors who expect their NOI to grow each year at a constant rate. The formula for the Gordon Growth Model is:
Stock value = Expected annual dividend cash flow / (Required rate of return – Expected dividend growth rate)
The formula can be applied to real estate to calculate the asset value of a property. When you factor in your expected growth rate, this helps you decide whether the property is worth purchasing at its offered price.
When to use Cap Rates
The Cap Rate is most useful when evaluating the long-term risk potential of rental properties that you expect will yield a regular, predictable income stream. Investors will frequently use the Cap Rate when considering property types, including:
- Single-family homes
- Multifamily rentals
- Apartment buildings
- Commercial properties
The Cap Rate isn’t a handy metric for properties that don’t provide stable income or have irregular cash flows. For instance, your net income will fluctuate with vacation rentals from month to month based on seasonal tourism. Your operating expenses will also vary, such as extra cleaning and maintenance costs during the months of high tenant turnover. If you’re planning to flip a home, you won’t be using the Cap Rate since your goal is to renovate and sell as quickly as possible.
Also, don’t forget that Cap Rate assumes that the property is paid for in cash and, therefore, doesn’t consider the costs of a mortgage.
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The Cap Rate can be an excellent real estate metric when used with other factors and is trusted by many investors as a reliable indicator of a property’s risk and return.
Rental properties can be an excellent way to get started in real estate investing, and if you’re ready to dive in, we’re here to help. At Arrived, we excel in finding the best rental properties. Our platform makes it easy for you to start investing in real estate by purchasing shares in any of our rental properties. To get started, browse our available properties.