The capitalization rate, or cap rate, is often used by real estate investors to determine the potential rate of return from a property. It can be a useful valuation tool when comparing investment properties and can be used to figure out if a property will yield enough of a profit. However, it does have its limitations and should be only one of several methods used to determine if an investment property is a good deal.
The cap rate is calculated like so:
| Cap rate | = | Net operating income (NOI) Current property value |
Cap Rate Calculation Examples
Below is an example of how the cap rate is calculated for two different properties. As you can see, it’s important to consider not only the property’s value and income but also any expenses associated with maintaining the property.
Property 1 | Property 2 | |
|---|---|---|
Income | ||
Annual Income | $40,000 per year | $60,000 per year |
Annual Expenses | ||
Property Management Fees | $1,000 | $2,000 |
Property Taxes | $5,500 | $9,375 |
Maintenance & Other Costs | $2,000 | $3,000 |
Homeowners Association (HOA) Fees | $500 | $0 |
Insurance Costs | $2,000 | $3,000 |
Utility Expenses | $1,500 | $2,500 |
Cost of Repairs | $2,000 | $3,000 |
Total Expenses | $14,500 annually | $22,875 annually |
Final Cap Rate Calculations | ||
NOI (Calculated as Income Minus Expenses) | $40,000 − $14,500 = $25,500 | $60,000 − $22,875 = $37,125 |
Property Value | $500,000 | $750,000 |
Cap Rate | $25,500 ÷ $500,000 = 5.1% | $37,125 ÷ $750,000 = 4.95% |
Why Cap Rate Is Important
Evaluating the cap rate of your investment can be used to compare different properties to determine the best ROI. You can use the calculation to aid in your investment decisions and help mitigate risk, and you can do this by considering the best- and worst-case scenarios for income and expenses to see how they would affect the cap rate.
What Is Considered a Good Cap Rate?
For real estate investments, a good cap rate is generally considered to range from 5% to 10%. Keep in mind that this is inclusive of a variety of factors like your risk tolerance, property location, and market cycle.
Generally, the higher the cap rate, the higher the risk to the property. This is because a high cap rate is often an indicator of a lower property value. With less expensive real estate, investors should be prepared for things like volatile property values, greater difficulty in attracting tenants, and maintaining high occupancy rates throughout the year.
Similarly, lower cap rates are associated with lower-risk investments. More expensive properties tend to be located in desirable areas, which usually means investors will have an easier time finding tenants and maintaining a high occupancy rate year-round.
Factors That Affect the Cap Rate
The value of a property is an important factor in determining the cap rate. While this can be obtained through traditional means, such as obtaining a formal appraisal inspection, the following are factors that typically impact a property’s value and its corresponding cap rate calculation:
- Location: Properties situated in locations that offer attractive amenities tend to draw in more tenants and generate higher rental rates. Properties close to amenities—such as shopping, entertainment, parks, highly rated schools, and employment centers—tend to be indicative of a more desirable property location.
- Features and amenities: A home’s features are another determining factor of the amount of rent tenants may be willing to pay. This can include things like the size of the home and the presence of a backyard, patio, or tennis court.
- Cost of financing: As rates increase and loans become more expensive, cap rates tend to increase, and property values tend to decrease since the buying power for borrowers goes down. To improve your chances of getting the best rate possible, read our guide on how to get a small business loan.
- Market conditions: Economical factors can impact cap rates and be influenced by supply and demand, unemployment rates, and real estate trends. In a strong market economy, there are likely more investment opportunities available that have strong rental history for a more optimistic ROI. In low market conditions, rental rates may be low and interest rates high, which can heighten the risk to an investment.
Who Should Use a Cap Rate
Calculating the cap rate of a potential real estate investment can be useful for investors looking to evaluate the potential risk and ROI of the property. It can also be used to compare multiple properties to determine which investment may be best for you. Both landlords and long-term investors of both residential and commercial real estate can use the cap rate for a variety of properties, including the following:
- Single-family investment homes
- Condominium and townhome rental properties
- 1- to 4-unit multifamily residential investment properties
- 5-unit or more apartment buildings
- Commercial real estate investment properties
When to Not Use a Cap Rate
There are instances where a cap rate calculation isn’t applicable. Generally, it shouldn’t be used to value real estate properties that are not expected to generate year-round rental income. Doing so will result in a skewed figure and will not give you a reliable indicator of the risk level or potential ROI.
Here are some examples in which a cap rate won’t apply:
- Vacation homes and short-term rental properties: Cap rate considers annual NOI, so properties that only generate rental income for several months throughout the year will not give you a reliable figure for the purposes of evaluating an investment property’s potential rate of return.
- Fix-and-flip investments: Fix-and-flip homes are typically short-term investments that are purchased and resold within six months. These properties are also unlikely to generate rental income and are, therefore, not good properties to evaluate with cap rate.
- Vacant land: Buying land will not yield any rental income, so the cap rate won’t be applicable here.
Alternatives to Valuing an Investment Property
A cap rate valuation has limitations and isn’t applicable in all real estate investment scenarios. That said, there are other ways of evaluating an investment property to determine if it’s worth your time. Consider the following calculation tools:
- The one percent rule: This states that rental income should be at least one percent of the property’s purchase price.
- The 50% rule: To factor in expenses involved with a rental property, this rule states that you should expect your expenses to be half that of your income. You can then use this figure in estimating things like cash flow and net profit.
- Price-to-rent ratio: This is calculated by using the median home value in an area and dividing it by the median annual rent. The ratio is intended to give you insight into whether it is cheaper for tenants to rent or purchase a home. As a rule of thumb, a ratio of 16 or greater usually means it is better to rent than buy.
- Per-unit price: This is calculated by taking a property’s purchase price and dividing it by the number of units that can be rented in a building.
- Cash flow: Cash flow tells you how much money you should have after all expenses have been considered. Take your rental income and subtract the costs of the rental property, such as loan payments, property taxes, insurance costs, and utilities.
- Gross rental yield: This is calculated by dividing a property’s annual rental income by the total cost of the property. The total cost of the property should include things like the purchase price, closing costs for obtaining a loan, and expenses incurred for renovations or upgrades. A rental yield of 7% or greater is typically considered to be good.
- ROI: You can calculate your ROI by taking your annual return and dividing it by the total cost of the purchase. In general, an ROI greater than 10% is considered desirable.
Unlike the cap rate, many of the methods mentioned above take your mortgage payments into consideration when evaluating an investment property.
- If you’re purchasing a residential home, you can get a low rate with the lenders on our list of the best investment property loans.
- If you’re looking to obtain commercial property, our guide on the leading commercial real estate rates goes over how rates are determined to help you get the best pricing available.
Frequently Asked Questions (FAQS)
The general rule of thumb is that the lower the cap rate, the lower the risk to the investment. However, a good cap rate typically ranges anywhere from 5% to 10% depending on the property type and current market conditions.
Factors such as property location, condition, size, tenants, and potential rent growth can impact the cap rate of your investment.
A cap rate calculation is based on NOI and market value and excludes depreciation or financing costs, such as interest and mortgage payments. It should not be used for investment properties that are classified as short-term or do not generate rental income.
Bottom Line
Using our cap rate calculator can help you when determining what is a good cap rate for a business investment property. This is one way to ensure that your ROI is worthwhile and that you are mitigating as much risk as possible. Our calculator is best used for properties that consistently generate year-round income and should be used, among other tools, to evaluate the value of your investment.
