This article is part of a larger series on Business Financing.
Real estate investors use the capitalization rate, or cap rate, to determine whether a potential investment property shows enough potential return on investment (ROI) to make it a worthwhile purchase. It’s based on annual returns, so if a property performed well or poorly for one year, this would be reflected in its calculation. The cap rate is calculated using the formula below, expressed as a percentage:
Cap rate = Net operating income (NOI) / Current property value
Cap Rate Calculator
Use the calculator below to compute a property’s cap rate:
Let’s look at a quick example of how to calculate NOI. Your gross rental income (assuming 100% occupancy) is $60,000, your occupancy rate is 85%, and your operating expenses are $15,000.
$60,000 x 85% = $51,000
$51,000 – $15,000 = $36,000 NOI
Cap Rate Examples
Below are two cap rate calculations based on two different properties. This will show you that the more expensive property isn’t necessarily going to have the better cap rate.
- Property value: $850,000
- NOI: $56,080
- Property value: $700,000
- NOI: $48,560
Divide the NOI by the property value to get the cap rate
- Property A: $56,080 / $850,000 = 0.066
- Property B: $48,560 / $700,000 = 0.069
Because the cap rate formula is expressed as a percentage, multiply now by 100:
- Property A: 0.066 x 100 = 6.6% cap rate
- Property B: 0.069 x 100 = 6.9% cap rate
Despite the fact that property B is less expensive, it has a higher cap rate, so it would be the better purchase just based on the cap rate. This is why before purchasing, you should look at the overall financial picture of the investment property, including ROI, cash flow, and what comparable properties are selling and renting for.
What Is a Good Cap Rate?
A good cap rate is anything over 4%. The higher the cap rate, the higher the financial yield the property will have. The lower the cap rate, the lower your ROI will be, and you may want to consider another investment property.
However, a lower cap rate also means that the property is a safer or lower-risk investment, while a higher cap rate means more risk. Understanding what the cap rate is, how it works, and alternative calculations for evaluating financial potential are critical before purchasing a new investment property.
Factors That Affect the Cap Rate
Since the cap rate doesn’t consider mortgage payments or the costs associated with purchasing the property and is simply a snapshot of the property over one year, the investor isn’t necessarily getting the full picture of the property’s performance over several years. So while it is a good tool to use, it is important to know the factors that can affect the cap rate, including
- Location: Property in a more desirable location will likely cost more to purchase, but rent will be higher as well. This is why you should use the cap rate because property in a desirable location might have the same cap rate as one in a less expensive location.
- Asset type: Commercial properties tend to have higher cap rates than multifamily properties, apartment buildings, and residential properties because commercial properties tend to have higher rent rates.
- Available inventory: The lower the inventory, the higher the demand, which leads to properties with lower cap rates.
- Interest rates: Rising rates tend to mean a fall in property values. Rising rates also increase debts, which decreases net cash flow. Because of this, rising rates can lead to lower cap rates.
When To Use the Cap Rate
Cap rate is used primarily by long-term investors looking to purchase property for rental purposes. In addition to long-term investors, landlords and commercial investors will consider the cap rate when evaluating a property.
Use the cap rate for
- Single-family investment properties
- Condo and townhome rental properties
- Commercial real estate investments
- Multifamily rental properties
- Apartment buildings
- Evaluating property landlords own before selling
When Not To Use the Cap Rate
The cap rate calculation doesn’t work for every investor and situation. If you’re fixing and flipping or buying vacant land, you aren’t renting out the property, so the cap rate doesn’t affect your purchase decision.
Generally, you won’t consider the cap rate in the following scenarios:
- Fixing and flipping: You’re selling the property for profit once it’s fixed, so you aren’t considering rental revenue potential when purchasing a property.
- Purchasing land: You can’t calculate rental income or NOI on vacant land, so the cap rate doesn’t apply here. Before purchasing vacant land, check out our guide on buying land.
- Buying a vacation rental property: Because the property may not be rented year-round, the cap rate won’t give an accurate representation of the value.
- Short-term rental property: Because the property is rented for short periods of time, and the cap rate is calculated based on annual income, the cap rate likely will be skewed.
Alternative Ways To Evaluate Investment Property
As mentioned above, there are other ways to evaluate investment properties. Be sure to consult with your financial advisor and consider multiple metrics for property performance before purchasing. Other evaluation methods include
- Comparable properties: Compare sales prices for comparable properties in the area to determine the value of a potential property.
- Per-unit price: Divide the potential purchase price by the number of rentable units in the building.
- Cash flow: Calculate the amount of rental income expected, and subtract expenses such as mortgage payments, taxes, insurance and utilities to determine overall cash flow.
- Gross rental yield: Divide the annual rent collected by the total property cost, then multiply by 100 to determine the gross rental yield. The total property cost includes purchase price, closing costs, and renovation costs. Anything above 7% is a good rental yield.
- The one percent rule: The gross monthly income should be a minimum of one percent of the purchase price. If gross monthly income is one percent or more of the purchase price, the property will usually have a positive cash flow.
- ROI: Divide your annual return by your total cash investment. Annual return is calculated by subtracting expenses from your total rental income. An ROI of more than 10% is good for real estate investment.
Before you purchase an investment or commercial property, calculate your potential cap rate to determine if the property is a good investment. While cap rate is a good tool, it should be just one of several factors considered when purchasing real estate. Consult your financial advisor during the evaluation process.
If you decide to take out a loan to purchase an investment property, be sure to check out our guide on how to get a small business loan to help you get started.