A capitalization rate, or cap rate, is used by real estate investors to evaluate an investment property and show its potential rate of return, helping decide if they should purchase the property. The cap rate formula is cap rate = net operating income/current property value. A good cap rate is typically higher than 4 percent.
What a Cap Rate Is & How It Works
A cap rate is a formula that investors often use as a tool to evaluate a real estate investment based off of a one-year period. It should be used to help determine if the property is a good deal. Instead of solely using the cap rate to determine if you should buy an investment property, we recommend using it as one of a few different evaluation tools.
The cap rate is calculated based on annual returns. This means that if a property performed well or poorly for one year, this shows up in the cap rate calculation. It also means that an investor isn’t getting an overview of the property for the past several years. It’s important to keep in mind that the cap rate shows the rate of return over one year, so if the property had prior years of poor performance, the cap rate might be deceiving in that is only shows one positive year of returns. It’s just something to keep in mind as you analyze the investment property further.
The cap rate is generally used by long-term investors that are purchasing residential or commercial rental property. Fx and flippers do not use it because they don’t intend to rent out the property. Cap rates should be compared to similar properties in the same asset class.
The capitalization rate is the ratio of net operating income to property asset value. The cap rate doesn’t take into account your mortgage payments or the costs associated with purchasing the property like lender fees and closing costs. That’s why, along with the cap rate, you should look at the overall financial picture of the investment property including its return on investment (ROI), cash flow and what comparable properties are selling and renting for.
Why a Cap Rate Is Important
A cap rate is an important tool for investors because it helps them evaluate real estate based on its current value and its net operating income (NOI). It gives them an initial yield on an investment property. An investor can look at a rising cap rate for a property and see that there’s a rise in income relative to its price. In contrast, a fall in cap rate generally indicates that there is lower rental income compared to its price. They can look at the cap rate before deciding if the property is worth buying or not.
When to Use the Cap Rate
You should use the cap rate as a way to evaluate a real estate investment. It’s typically used prior to purchasing a property but can also be used once you already own the property and before you put the property on the market to sell it.
The capitalization rate is a tool to help you evaluate a property and should be used by investors in addition to other tools. Typically, a buy and hold investor will use the cap rate as well as landlords and commercial investors. It makes sense to use the cap rate on residential and commercial properties that are currently rented.
The cap rate can be used for:
- Single-family investment properties
- Condo and townhome rental properties
- Commercial real estate investments
- Multifamily rental properties
- Apartment buildings
- Landlords who want to evaluate a property they already own and may consider selling
When Not to Use the Cap Rate
There are certainly many scenarios when using the cap rate formula is appropriate. However, there are times when using the capitalization rate doesn’t make much sense. You shouldn’t use the cap rate if you’re a fix and flipper or if you’re buying a vacant property.
Typically, you shouldn’t use the cap rate for the following scenarios:
- Fix and flip: Fix-and-flip investors purchase real estate with the intention to rehab it and sell it quickly for a profit, so they don’t use the capitalization rate to determine if the property is a good investment. They’re not interested in the rental income because their exit strategy is selling the property and not renting it out.
- Purchasing land: When evaluating land, an investor doesn’t usually use the capitalization rate because the land typically is vacant and, therefore, doesn’t have any rental income so the NOI can’t be calculated. Instead, the investor should research the land thoroughly, including its current and allowed zoning, which is important if you want to resell the land. You should also research the utility accessibility and do a survey of the land, so you know what you’re buying. For more information on how to buy and evaluate land, read our in-depth guide on how to buy land.
- Purchasing a vacant or unoccupied property: The cap rate formula depends on NOI, so it generally shouldn’t be used if the property is vacant because it doesn’t have any rental income to take into account. Although some investors use projected rental income, it’s not very common because it may be inaccurate, and it’s difficult to estimate expenses on a vacant property.
- Purchasing a vacation rental property: Although a vacation rental property is rented and will have NOI and operating expenses, it skews the results of the capitalization rate formula because it’s not rented year round. Part of the year, the owner will use the property as a vacation home, so a cap rate doesn’t give the property an accurate representation of value.
- Short-term rental property: Similar to a vacation rental property, a property that offers short-term rentals also skews the cap rate because the rental terms are generally for days or weeks and a cap rate is calculated annually.
Cap Rate Formula
Cap Rate = Net Operating Income / Current Property Value
The cap rate formula is the net operating income divided by the property value.
The cap rate formula is calculated on an annual basis. Keep in mind that investors sometimes calculate this differently. The capitalization rate formula can be calculated with or without the occupancy rate, but it’s more accurate using the occupancy rate if you know what that number is.
First, let’s discuss how to figure out the NOI. This is relatively simple to figure out by subtracting the operating expenses from the gross rental income. Next, you need to figure out what the property value is. This is not necessarily the same as the purchase price of the property. For more information on terms used in the cap rate formula, review the key terms section below.
If you decide to incorporate the occupancy rate into your cap rate formula, then you would take the gross rental income, multiply it by the occupancy rate and then subtract your operating expenses.
Cap Rate Calculation Examples
We’re going to go through a few cap rate formula examples. First, let’s look at two multifamily properties and how their cap rates compare. Remember, if you want an accurate cap rate comparison, you should compare properties in the same asset class like multifamily properties and commercial buildings. Properties should also be in the same area, such as rural, suburban or urban.
1. Let’s assume we’re analyzing two multifamily properties in an urban area. Property A has six units, and Property B has eight units.
Property value: $850.000
Occupancy rate: 98%
Gross rental income: $96,000
Operating expenses: $38,000
Property value: $700,000
Occupancy rate: 98%
Gross rental income: $72,000
Operating expenses: $22,000
The first step is to multiply the occupancy rate by the gross rental income:
Property A: 98% x $96,000 = $94,080
Property B: 98% x $72,000 = $70,560
Next, subtract the operating expenses:
Property A: $94,080 – $38,000 = $56,080
Property B: $70,560 – $22,000 = $48,560
Now that you have the NOI, divide that 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
As you can see from this example, both properties have very similar cap rates, and Property B is significantly less expensive than Property A. If an investor was analyzing properties based on sales price and cap rate, generally they would choose Property B.
Now, let’s look at two more cap rate formula examples — one using the occupancy rate and one without it:
- Property value: $500,000
Occupancy rate: 90%
Gross rental income: $60,000
Operating expenses: $20,000
The first step is to multiply the occupancy rate by the gross rental income:
90% x $60,000 = $54,000
Next, subtract the operating expenses:
$54,000 – $20,000 = $34,000
Now, you have the NOI which is $34,000. Next, divide the NOI by the property value:
$34,000 / $500,000 = 0.068
The capitalization rate formula is generally expressed as a percentage, so you multiply 0.068 by 100:
0.068 x 100 = 6.8%
This means that your cap rate is 6.8%
2. Now we’re going to use the same numbers but not incorporate the occupancy rate to see how our outcome is different. We know that the gross rental income is $60,000 and our operating expenses are $20,000, so we subtract the operating expense from the gross rental income:
$60,000 – $20,000 = $40,000
$40,000 is the NOI. Then, we divide the NOI by the property value:
$40,000 / $500,000 = 0.08
Then, we multiply by 100 to get the fraction:
0.08 x 100 = 8% cap rate
As you can see from the above examples, when we don’t use the occupancy rate, we get a higher cap rate because it assumes that the property is occupied 100 percent of the time, which usually isn’t the case. The cap rate from the first example will generally be more accurate because it’s taking into account when the property is vacant.
Now, let’s use the cap rate formula in a different scenario. Let’s assume that we already own an income-producing property, and we know what the NOI and the cap rate are, but we’re unsure of the property value. We can work backward to figure this out. To figure out the current property value, you would divide the NOI by the cap rate.
For example, you know that the NOI is $20,000 and the cap rate is 10 percent. Then, the property value would be:
$20,000 / 10% = $200,000
What Is a Good Cap Rate?
Generally speaking, a cap rate that falls between 4 percent and 10 percent is typical and considered to be a good cap rate. However, it does depend on the demand, the available inventory in the area and the specific type of property. What is a good cap rate can be subjective and various real estate investors with dissimilar investing strategies look at it differently.
For example, a 4 percent cap rate may be the norm in high-demand areas such as in and around large metropolitan areas and high-cost areas like Southern California and New York City. In contrast, a lower-demand area like a rural neighborhood or an up-and-coming neighborhood that is in the process of gentrification, you may see a cap rate of 10 percent or higher.
Typically, buyers want a high cap rate, meaning the purchase price is relatively low in comparison to the NOI. However, a higher cap rate typically means more risk and a lower cap rate represents lower risk. A property with a high cap rate may be located in an area where there isn’t much opportunity for increasing the rent rates or where property appreciation isn’t on a scale with other areas. An investor needs to weigh the risks and determine an appropriate cap rate for their investment goals.
A property with a high cap rate may not take into account the occupancy rate, it may use expected rents and not current rents or it may be in an area where there isn’t much demand for investment properties. Conversely, a property with a low cap rate may be in an expensive area, near downtown and may be considered more desirable and have more demand for that type of property. Keep in mind that you should check how the cap rate was derived so you understand the full financial picture of the real estate investment.
Keep in mind that you should compare apples to apples when deciding if a property has a good cap rate. This means that cap rates should be compared among the same types of properties in similar areas. A multifamily investment property will generally have a much lower cap rate than a commercial building with retail tenants. This makes a multifamily property a lower risk and potentially lower reward investment. This is because people always need somewhere to live and, if the economy takes a turn for the worse, retail tenants are less likely to pay than multifamily tenants.
“The idea of “good” or “bad” cap rates are in the eye of the beholder — the higher the cap rate, usually the higher the risk. In our target markets and asset class, we are seeing cap rates between 5 percent and 6 percent that, when leveraged conservatively, can create cash-on-cash returns of 8 percent to 9 percent.” — Andrew Campbell, Co-founder & Managing Partner, Wildhorn Capital
Factors That Affect Cap Rate
A good or bad cap rate can be perceived differently by different investors. Varying cap rates are seen among categories and types of residential and commercial real estate. However, there are a few factors that affect the cap rate like property location and demand in the area.
Factors that typically affect cap rate include:
- Location: Property location drives demand and dives the local economy; generally, a more desirable location means a higher fair market value of a property and higher rents, so typically the cap rate remains unchanged
- Asset class: This is the type of property such as multifamily, apartment building, industrial or commercial property and typically residential properties have lower cap rates than commercial properties because commercial properties tend to have higher rents
- Available inventory: This is how many properties are available in the area and, typically, the lower the inventory, the higher the demand, which tends to lead to properties with lower cap rates
- Interest rates: Rising rates typically mean a fall in property values; when rates rise, debts typically rise which decreases net cash flow; this means that rising rates can lead to lower cap rates
“Cap rates have seen downward compression since the Great Recession as U.S. Treasuries have remained steady and the interest rate environment has remained low. That being said, the inverse relationship between cap rates and interest rates will begin to reveal itself as the Federal Reserve moves toward gradually increasing rates.” — Lucas Fryman, Director, Interra Realty
Key Terms Related to Cap Rate
To understand what a cap rate is and how it works, you first need to understand a few key terms. These terms will help you figure out the cap rate formula, understand why a cap rate is important and evaluate the property.
The key terms used when discussing cap rate are:
- Gross rental income: The total amount collected in rent and any related rental property income before any expenses are deducted; you can include rent for parking and other factors
- Net operating income (NOI): This is the annual income generated by an income-producing property after deducting all operating expenses
- Operating expenses: Expenses needed to operate the property which includes property taxes, rental property insurance, management fees, repairs, maintenance and miscellaneous things like accounting and legal fees
- Occupancy rate: The ratio of rented space to the total amount of available space and is typically used in multi-unit properties
- Property value: The current fair market value of a piece of real estate; this is not the purchase price
Additional Ways to Evaluate Investment Property
There are several other ways to evaluate an investment property besides using the cap rate formula. We recommend using two to three methods when evaluating investment property. This gives you a more well-rounded view of the property and whether or not it has the potential to be a good investment. If the property isn’t rented, needs to be rehabbed or you don’t know the market rents, then you may want to use an additional evaluation tool.
Some additional ways to evaluate investment property include:
- Comparable properties: Look at what other comparable properties have sold and rented for in the past three to six months; comparables should be the same type of property, have similar amenities and be similar in size
- Per-unit price: This compares the per unit price of an investment property
- Cash flow: Evaluate the property’s potential cash flow by checking to see if the expected monthly rent will cover your costs including mortgage payment, taxes, insurance, utilities and homeowners’ association fees
- Gross rental yield: This number can be found by dividing the annual rent collected by the total property cost and then multiplying by 100; the total property cost includes the purchase price, closing costs and any renovation costs
- The 1 percent rule: The gross monthly income should be a minimum of 1 percent of the purchase price; some investors use the 2 percent rule, depending on the property type and location; if the property’s gross monthly income is 1 percent or more of the purchases price, it’s usually cash flow positive
- Return on investment (ROI): Typically, 10 percent or more is a good ROI for a real estate investment; you can figure out your ROI on an investment property by calculating your annual return and dividing that by your total cash investment; you figure out your annual return by subtracting your expenses from your total rental income
Cap Rate Frequently Asked Questions (FAQs)
Here are some answers to frequently asked questions on cap rate pertaining to real estate. If you have additional questions or would like to comment on the subject, please visit our forum.
What Is the Cap Rate Definition?
The cap rate definition is a rate used to help investors evaluate a real estate investment. It is a formula that shows the potential rate of return on a property. The cap rate formula is generally the NOI divided by the current market value of the property, and the answer is a percentage.
What Is a Cap Rate Calculator?
A cap rate calculator is a tool that helps you determine the rate of return on your real estate investment. It includes inputs such as property value, gross annual rental income, operating expenses and vacancy rate. After the investor fills in the inputs, the cap rate calculator will give an output of your capitalization rate.
What Is Cap Rate Real Estate?
Cap rate real estate is referring to using the capitalization rate in real estate, which is where it’s most commonly used. It can be used to evaluate commercial and residential properties, including duplexes, triplexes and apartment buildings. Investors typically use a cap rate in real estate as a tool to help them evaluate a property and the potential rate of return it will have.
Do You Want a Higher or Lower Cap Rate?
Investors who are purchasing a real estate investment property generally want a higher cap rate because this means that the value or purchase price of the property is relatively low in comparison to the NOI. However, a seller may want to see a lower cap rate because this means that the sales price is higher.
The Bottom Line
Investors use a cap rate as a tool to help them evaluate a piece of real estate based off of the NOI and current fair market value. The cap rate formula is used to show the potential rate of return on a real estate investment. A good cap rate in real estate varies but is generally 4 percent to 10 percent or higher.