What is a Cap Rate In Real Estate?

The capitalization rate, or cap rate, is a key metric used in real estate investing to evaluate the potential return on an income-producing property. It helps investors quickly assess whether a property is a good investment by comparing its annual net operating income to its purchase price.

While simple to calculate, understanding what makes a good cap rate and how it fits into broader investment strategies can be complex. In this post, we’ll explain what a cap rate is, how it’s calculated, and how you can use it to make more informed real estate investment decisions.

Importance of a Cap Rate in Real Estate

The cap rate helps real estate investors predict a property’s annual net income. A higher cap rate means that a property holds a strong potential for profit. Investors may also opt to make the minimum monthly mortgage payments and use the extra cash flow to invest in additional properties. 

A low cap rate indicates a property does not have as much potential, and investors should consider the type of risk they incur to end up with a low cap rate. Some investors set a minimum cap rate and refuse to buy properties that do not fulfill the minimum.

When Should I Use a Cap Rate for Evaluating Real Estate?

The cap rate is valuable for real estate investors who buy cash-flow-producing assets. This metric isn’t as valuable if you want to flip a home. However, if you want tenants, you should use the cap rate to calculate your annual net income from the property.

What is a Good Cap Rate in Real Estate?

A good cap rate is between 5%-10% and depends on the location. Big cities let you charge higher rent and potentially collect higher net operating incomes, but high property prices can drag down the cap rate. A high cap rate can indicate higher potential returns, but it can also indicate a riskier area. It may take longer for a property with a high cap rate to generate a return for the investor. 

How to Calculate a Cap Rate in Real Estate

The calculation for cap rate is simple. You have to divide the property’s value by the net operating income. Net operating income is the difference between revenue and operating expenses.

Here is the formula for calculating the cap rate:

Cap rate = Net operating income / Property value

A property worth $500,000 that yields $20,000 in annual net operating income has a cap rate of 4%. Here is the calculation:

Cap rate = Net operating income / Property value

Cap rate = $20k / $500k = 4%

The cap rate is a bit on the low end and may not fulfill the benchmark requirement for some investors’ portfolios. An investor may spot opportunities to lower operating expenses or fill up more vacancies to increase net operating income. An annual net operating income above $25,000 can make the property more enticing for investors.

How to Interpret Cap Rate for Real Estate Investing

What happens when you figure out the cap rate? It doesn’t guarantee your investment will be profitable, but knowing how to interpret it can give you reassurance in your convictions.

Understand How to Calculate the Cap Rate for Real Estate

The formula for the cap rate is “Net Operating Income / Property Value.” Higher gross income, lower operating income and a lower property purchase price will all improve the cap rate.

Relationship with Property Value

Higher cap rates indicate higher potential returns in relation to the property’s net operating income and value. A lower cap rate indicates lower returns but can also be associated with a less risky property.

Comparison to Market Rates

Cap rates aren’t universal. These rates vary across locations, property types, market conditions and other parameters. It’s important for investors to look at cap rates of similar properties in the area to see if they are getting a fair deal. If the average cap rate in your area is 8%, and the property you are looking at has a 6% cap rate, you may want to negotiate a lower price to match an 8% cap rate.

Risk Assessment

Cap rates help investors gauge a property’s risk. Just as high dividend yields can indicate a risky stock, a high cap rate can indicate a risky real estate investment. Lower cap rates don’t yield as much profit but are typically more stable. Tenant stability, market conditions, lease terms and location impact the property’s risk and cap rate.

Income Potential

Cap rates reflect a property’s income potential and how much an owner can raise the rent in future years. While income potential can lead to greater gains and help with retirement goals, potential is only potential. Investors should assess if income growth is stable and consistent or if most of the recent growth feels like a short-term blip. Investors can still realize returns from properties with lower cap rates that offer more stability.

Consideration of Other Metrics

The cap rate is far from the only metric in real estate, and no investor lets one statistic dictate their decisions. Investors should consider additional metrics like financing costs, property appreciation, cash flow, and others. Investors should also see if the property aligns with their investment goals. Combining these factors can give you greater clarity on if the cap rate makes sense for you.

Factors That Can Affect the Cap Rate in Real Estate

The cap rate is a simple formula, but a lot goes into it. Investors should anticipate these factors influencing a property’s cap rate.

Property Location

The success of a location can make or break a real estate investment. Population growth, economic strength and convenient access to transportation and amenities result in lower cap rates and more stability.

Property Type

Commercial properties tend to have different cap rates than residential properties. The type of property impacts the risks and potential returns, thus determining the cap rate in the process.

Market Conditions

The local real estate market plays a significant role in property prices. A buyer’s market features excess properties and results in lower valuations. The lower valuations result in higher cap rates which are more attractive for investors. A seller’s market occurs during a property shortage and increases property values. Higher property values decrease cap rates, but investors may have to deal with it because of shortages. Investors can also opt to wait for market conditions to improve before buying real estate.

Economic Factors

Interest rate hikes and inflation have made headlines over the past few years. These metrics impact the prices of goods and services, consumer spending and property prices. Real estate investors should also monitor employment rates and GDP. Interest rates have an outsized impact on real estate investments since interest rates dictate the cost of borrowing money. Higher interest rates lower property values, while lower interest rates increase property values.

Rental Income and Expenses

Potential changes to rental income and expenses will impact your net operating income, the numerator in the cap rate equation. Properties with more potential for rent hikes can command higher profits and increase the cap rate. Investors should look at current numbers and how those numbers can change in the future.

Tenant Quality and Lease Terms

Real estate investors want stability. They want tenants who stick around, pay rent for years and keep the property in good condition. High tenant quality and optimal lease terms often result in lower cap rates since there is more stability. While uncertainty in these areas is risky for investors, it can also result in higher cap rates.

Property Condition and Maintenance

A well-maintained property will have a lower cap rate. These properties are less likely to have random, urgent expenses. Properties that need more help typically have higher cap rates from the extra risks involved.

Financing Costs

Higher financing costs result in higher cap rates, while lower financing costs result in lower cap rates. Interest rates and loan terms impact the cost of borrowing money.

Investor Demand and Sentiment

How investors feel about a location and its properties can impact cap rates. Strong investor demand can lower cap rates because this demand can result in a seller’s market. If investors do not feel as confident about an area, the cap rates can increase in the emergence of a buyer’s market.

Market Liquidity

High liquidity reduces an investor’s risk and results in lower cap rates. If it takes several months for properties to get sold, the increased risk can raise the cap rate.

Advantages of Using a Cap Rate for Evaluating Real Estate Investments

Using a cap rate for evaluating real estate investments comes with several advantages.

• Assess a property’s expected return: You can use this metric to discover a property’s potential instead of guessing.
• Risk tolerance: A higher cap rate typically indicates a property is riskier than average. Lower cap rates indicate the opposite, and it’s good to know this information before committing to a property.
• Know your price: Some investors aim for a minimum cap rate. Knowing this number, an investor can reverse engineer the cap rate formula to determine the maximum price they will pay to acquire the property.

Disadvantages of Using a Cap Rate for Evaluating Real Estate Investments

While the cap rate is a useful metric, it isn’t perfect. Here are some of the disadvantages of using the cap rate to evaluate investments.

• Overreliance: If you only use the cap rate, you risk missing out on the bigger picture. It does not account for property appreciation, the lack of it and other factors. Using other metrics and information can help you make better investing decisions.
• The cap rate isn’t guaranteed: Market conditions can change significantly and impact your net operating income. The cap rate makes assumptions that may or may not play out.

Add Cap Rate to Your Investing Toolbox

Knowing a property’s cap rate can make you feel more confident about an investment or cause you to walk away from it. The cap rate isn’t the only metric savvy that real estate investors use, but it can become the foundation for an effective investment strategy. Using it alongside other information can lead to the best results.

Frequently Asked Questions