The cap rate of a property is determined based on its potential revenue and risk level as compared to other properties. Importantly, the cap rate won’t provide a total return on investment. Instead, it will indicate an estimate of how long it will take to recover your initial investment in a property.
To effectively use this metric, you’ll need to learn how to calculate the cap rate. The formula for cap rate is:
Cap Rate = Net Operating Income (NOI) ∕ Current Market Value × 100
Let’s walk through an example to better illustrate how to use this formula.
1. Calculate The Property’s Net Operating Income
First, you’ll need to learn how to calculate the net operating income (NOI). The NOI is essentially the sum of a property’s income streams minus the sum of the property’s expenses.
Add up the property’s income streams by including any form of income it can produce, such as rental income, fees and on-site amenities that require additional fees.
For this example, let’s say you’re considering a property that brings in $5,000 per month in rental income without any additional income streams.
Determine The Property’s Total Operating Expenses
Next, add up the property’s expenses. The obvious expenses to include are property taxes, insurance premiums, repairs and legal costs. However, there are less obvious expenses that should be included, such as potential vacancies. Most investors assume an average of 10% vacancy, but you can do some research in your local area to determine an accurate estimate of the property’s expected vacancy rate.
For the property you’re considering, the total expenses are $1,000 per month, which includes a 10% vacancy expectation.
If you qualify with rental income to buy the property, most lenders may assume a vacancy rate of up to 25%.
Subtract Total Expenses From The Total Income
Once you’ve determined the property’s income and expenses, you can subtract the costs from the income. At that point, you’ll determine the NOI. In our case, the net operating income for the property is $4,000 per month or $48,000 per year.
2. Divide By The Current Market Value
The next step is to divide the net operating income by the current market value. Although there is some debate among investors on whether to use the current market value or the purchase price, the majority of investors work with the current market value of the property.
With that in mind, we’ll stick to the more widely accepted formula and divide the net operating income by the current market value. You can find the property’s current market value by checking out the property details and exploring one of the many home valuation estimation tools available or with a comparative market analysis.
In our example, the current market value of the property is $480,000. We can plug the market value into the formula to determine the cap rate. $48K / $480K = .1.
3. Convert Into A Percentage
The final step is to convert the product of your division into a percentage. You can do this by multiplying the result by 100.
In our case, we can simply multiply 0.10 by 100 to arrive at a cap rate of 10%. This percentage is how the cap rate is represented.
The cap rate is the most popular measure through which real estate investments are assessed for their profitability and return potential. The cap rate simply represents the yield of a property over a one-year time horizon assuming the property is purchased on cash and not on loan.
Calculated by dividing a property's net operating income by its asset value, the cap rate is an assessment of the yield of a property over one year. For example, a property worth $14 million generating $600,000 of NOI would have a cap rate of 4.3%.
A vacation rental property with a 7.5% cap rate has an annual net operating income that's 7.5% of the home's purchase price. So, for instance, a $250,000 home with an NOI of $18,750 has a 7.5% cap rate.
Average cap rates range from 4% to 10%. Generally, the higher the cap rate, the higher the risk. A cap rate above 7% may be perceived as a riskier investment, whereas a cap rate below 5% may be seen as a safer bet. If a property has a 10% cap rate, you should expect to recover your investment in about 10 years.
If you invested $1,000,000 in a property, with a 6% CAP rate, you would receive $60,000, at year-end. Or if your commercial real estate property is generating $100,000 of net operating income per year and the market's CAP rate is 10%.
It's generally better to have a lower cap rate than a higher one. A lower cap rate implies that the property is more valuable and less risky due to type, class, and market. While a higher cap rate offers investors a higher return, that property investment typically has a higher risk profile.
Generally, the capitalization rate can be viewed as a measure of risk. So determining whether a higher or lower cap rate is better will depend on the investor and their risk profile. A higher cap rate means that the investment holds more risk whereas a low cap risk means an investment holds less risk.
In general, people tend to agree that a “good” cap rate can be anywhere from 5-10%, but even this should depend on your risk tolerance, the specific asset class, and your ideal time horizon for the investment. So while cap rates can be useful, they should never be the only metric you should consider.
In real estate, a low (less than 5%) cap rate often reflects a lower risk profile, whereas a higher cap rate (greater than 7%) is often considered a riskier investment. Whether an investor deems a cap rate “good” is a direct reflection of whether or not they think the investment's return matches its perceived risk.
Following the 2% rule, an investor can expect to realize a gross yield from a rental property if the monthly rent is at least 2% of the purchase price. To calculate the 2% rule for a rental property you need to know the property's price. You could then take that number and multiply it by 0.02.
Applied to real estate, the 2% rule advises that for an investment property to have a positive cash flow, the monthly rent should be equal to or greater than two percent of the purchase price.
Cap Rate → The cap rate, or “capitalization rate”, measures the potential yield earned on a rental property investment while neglecting the usage of leverage. Cash on Cash Return → In contrast, the cash on cash return, or “cash yield”, represents the profit earned per dollar of equity invested into a rental property.
Through the lens of real estate investing, understanding the difference between cap rates and yields is vital. The cap rate gives an inkling of the property's inherent risk profile and potential return, while the yield provides insight into the total return on your total investment, including debt.
Cap rate and ROI are not the same. The cap rate is the expected return based on the property value, but the ROI is the return on your cash investment, not the market value.
The 50% rule or 50 rule in real estate says that half of the gross income generated by a rental property should be allocated to operating expenses when determining profitability. The rule is designed to help investors avoid the mistake of underestimating expenses and overestimating profits.
Put simply, the 70 percent rule states that you shouldn't buy a distressed property for more than 70 percent of the home's after-repair value (ARV) — in other words, how much the house will likely sell for once fixed — minus the cost of repairs.
Investors hoping for deals with a lower purchase price may, therefore, want a high cap rate. Following this logic, a cap rate between four and ten percent may be considered a “good” investment. According to Rasti Nikolic, a financial consultant at Loan Advisor, “in general though, 5% to 10% rate is considered good.
The Capitalization Rate or Cap Rate is a ratio used to estimate the value of income producing properties. Put simply, the cap rate is the net operating income divided by the sales price or value of a property expressed as a percentage.
An investor who pays $10 million for a building at a 10% cap rate would expect to generate $1 million of net operating income from that property each year. If that same investor paid $20 million for the same property, but still only earned $1 million in net operating income, we'd refer to this as a 5-cap.
Introduction: My name is Saturnina Altenwerth DVM, I am a witty, perfect, combative, beautiful, determined, fancy, determined person who loves writing and wants to share my knowledge and understanding with you.
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