What Is a Cap Rate in Real Estate & Why Is It Important?
July 20, 2022
When considering real estate investing, there are many numbers to look at and factors to consider. Among those numbers is the cap rate. You might wonder what is a cap rate in real estate and why is it important?
We break it down for you below.
What Is a Cap Rate in Real Estate?
The cap rate in real estate estimates your rate of return on a property investment. Of course, like any investments, such as stock market investments, there's no way to know 100% what your rate of return will be, but the cap rate is a reasonable estimate.
The cap rate is the property's net operating income divided by the purchase price. Many real estate investors think of it as their crystal ball or outlook of how much a property may earn them if all economic indicators remain positive.
When Is Real Estate Cap Rate Used?
The importance of a cap rate in real estate is most prevalent when choosing between investment properties or deciding if an investment property is a good option. The real estate cap rate formula works best on rental properties versus fix and flip or the purchase of raw land.
Uses and Limitations of Cap Rate
Like any metric, cap rates have uses and limitations you should consider.
Real estate investors often use cap rates to compare the risk or reward of potential properties in an area. A higher cap rate can mean higher risk, but not always. Real estate investors need to look into the real estate investment property to determine why a cap rate is higher than the market average.
For example, the property may be undervalued because it needs some work, or the seller may overinflate the income compared to the market value.
The cap rate calculation can help investors compare potential real estate investments, but there are some limitations.
For example, the cap rate equation uses the net operating income from the last 12 months. But, as we've all seen in the previous two years, gross rental income can change drastically based on what's happening in the economy. Therefore the income used for the cap rate calculation can be over or understated.
Another major limitation of the cap rate is that it doesn't include any mortgage payments. So if you leverage your investment by borrowing money to buy a rental property, the cost isn't reflected in the capitalization rate formula.
What Is the Importance of a Cap Rate in Real Estate?
Since the cap rate has limitations, you might wonder if there's any importance of the cap rate in real estate.
There is plenty of importance as long as investors realize it's an estimate of the potential risk and reward and that factors can change quickly.
Overall, real estate investors use the cap rate in real estate to compare it to other investment opportunities. For example, if an investor has the option to invest in a security investment for a 5% cap rate and a real estate investment for a 9% cap rate, it's easy to decide between the two.
Another reason the cap rate formula is essential is to determine how long it might take to recoup an investment. For example, a real estate cap rate of 5% may take five years to recoup your investment. Investors can use this information to determine if an investment property is worth it based on their timeline.
How to Calculate Cap Rate
Learning how to calculate the capitalization rate is simple. You need two bits of information to calculate it. First, you'll need the net operating income and the purchase price.
Cap Rate Formula
The cap rate formula is simple:
Net operating income/Purchase price x 100 = Cap Rate
The cap rate formula considers the net operating income but doesn't specifically consider the occupancy rate. The formula assumes 100% occupancy, which isn't a reality for most investment properties.
Considering a 5 - 10% vacancy rate can provide a more realistic cap rate, helping you make a more informed decision and potentially take a lower risk.
Cap Rate vs ROI
The cap rate and ROI are two often confused metrics. Since the real estate cap rate is your estimated return on investment, the two metrics seem the same. The ROI focuses on the individual return on a single investment. The cap rate helps you compare the ROI on multiple properties. You can compare the cap rates to determine which rental property offers the best risk and reward combination.
You can use the cap rate formula on just about any property type to determine which real estate investment makes the most sense, even if they have the same net operating income. However, the cap rate calculation is most commonly used on single-family homes, townhomes, multifamily properties, and commercial real estate.
The property value or purchase price are the determining factors in the cap rate calculation. You divide the annual net operating income by the property value or purchase price to determine the cap rate. For example, the lower property value may overstate the cap rate if you're buying an undervalued property.
The lower a property's vacancy rate is, the higher the NOI will be. But cap rate doesn't consider the vacancy rate. So it's a good idea when calculating the capitalization rate to consider the area's average vacancy rate, so you use an accurate NOI.
Age of Property
Older homes often need more renovations or repairs, which decreases the net operating income. Consider the property's age and the potential renovations it will need in the near future to ensure you use an accurate calculation for the net operating income.
What Is a Good Cap Rate in Real Estate?
A reasonable cap rate varies by location. There isn't one number we can say is the right or best cap rate for a real estate investment. Since cap rates are a means to compare potential investment opportunities, you should look at how they compare to one another rather than looking for a specific number.
However, before comparing cap rates, think about what you want from your real estate investment. The two most common factors to consider are the cash flow and rate of appreciation.
Properties that produce good cash flow for the area typically don't appreciate fast, and properties that appreciate fast usually have lower cash flow. Usually, higher cap rate properties have higher cash flow and slower appreciation and vice versa.
Calculating Capitalization Rate Example
To understand how to determine a cap rate, here is a quick example.
Suppose you bought a property for $250,000, and the property's net operating income is $15,000. Your cap rate would be $15,000/$250,000 x 100 = 6%.
You can also use the cap rate and a property's NOI to determine how much you're willing to pay for a property.
For example, if you want a capitalization rate of 8% and a property's net operating income is $10,000, you'd want to pay no more than $125,000 to make the investment worthwhile.
Cap Rate Meaning FAQ
Can Cap Rate Change?
Cap rates can change based on what you do with the property. For example, if you renovate the property, increasing its value, you lower the cap rate because you increase the profit. But, if you increase the value and can increase the rent, you may increase the cap rate for greater cash flow.
What Is Cash Flow?
The cash flow you earn on a property is the money you earn from the rental income after paying the operating expenses. The expenses include mortgage, utilities, repairs or renovations, and other related expenses.
What Is the Internal Rate of Return?
The Internal Rate of Return or the IRR is the potential return you'll earn on a property based on the possible cash flow and property appreciation. Since these numbers are estimates, this isn't a guarantee of what you'll earn but an estimate of what to expect to help you make investing decisions.
What Is the Gordon Model?
The Gordon Growth Model is the equivalent of the capitalization rate but for stocks. It calculates a stock's inherent value. To calculate the Gordon Model, use the following equation:
Required rate of return - Expected growth rate = Expected cash flow/Asset value
To equate it to real estate, the expected cash flow is the NOI, and the asset value is the market value.
What Is a Capitalization Rate: The Bottom Line
The cap rate is one measurement when deciding if a real estate investment is worth it. Of course, it shouldn't be the only metric you consider, but it can be a good way to compare real estate investment options to help you choose the one that provides the desired return. Learn more by signing up and visiting our blog.
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