The cap rate, or capitalization rate, is used to compare commercial real estate returns on investment quickly. It shows the rate of return to generate the real estate investment property. While the cap rate shouldn’t be the only measure investors use, it is useful to gauge expected income quickly and performance quickly. Below, you’ll find what a good cap rate is by investment type and factors that can influence cap rate.
Why a Good Cap Rate is Important for Investors
Investors use the cap rate to compare commercial properties and gauge how much return they can expect from an investment. It is commonly used in property assessment for real estate investing. While there are other mathematical calculations and factors that need to be weighed before purchase, the cap rate offers an initial screening tool to gain insight into a property.
Cap rates are influenced by location, market size, asset stability, growth potential and capital liquidity, making it a single encapsulation of many common real estate variables.
You can calculate the cap rate on any property with a simple mathematical formula.
Capitalization Rate = Net Operating Income / Current Market Value
That means that if the net operating income on a property is $20,000 and its current market value is $300,000, the cap rate is:
$20,000 / $300,000 = 0.06 or 6%
Since cap rates are usually expressed as a percentage, this property’s cap rate would be 6%. This is considered a good cap rate.
Many market analysts suggest that you should look for an ideal cap rate between 5% and 10%, but this varies by property type and location. A lower cap rate means you take on lesser risk but may take longer to recover the investment.
What is a Good Cap Rate for Rental Properties?
A good cap rate for rental property varies by property type and location. While rental properties with a 5% to 10% cap rate are usually considered good, this can vary from investor to investor and region. It's important to consider what is a good cap rate for rental property in the specific location you're considering. For example, average cap rates in major cities range from 4.80% in Los Angeles to 7.10% in Chicago for retail property rental space.
What is a Good Cap Rate for Commercial Real Estate Investments?
A good cap rate for commercial real estate varies widely and is influenced by property type, location and market conditions. Experts suggest that a good cap rate for real estate investment ranges from 4% to 10%.
However, the higher the cap rate, the higher the risk. A cap rate above 7% may be riskier, whereas a cap rate below 5% can offer less risk. Common cap rates for commercial office space in major cities range from 5.10% in San Diego to 8.40% in Chicago. For industrial properties, the cap rate ranges from 4.40% in Orange County to 6.90% in Cleveland and 7.70% in Chicago.
What is a Good Cap Rate for Multifamily Investment Properties?
Multifamily investment properties are influenced by unique market factors, demand, economic changes and location. A good market cap rate for multi-family properties ranges from 3% to 10%, with higher percentages indicating additional risk with the possibility for higher returns. Cap rates for multifamily investment properties in major cities range from 3.60% in San Diego to 8.90% in Cleveland to 5.10%.
What is a Good Cap Rate for Single-Family Homes?
Single-family homes offer an even wider margin of good cap rates. In strong single-family markets, cap rates generally range from 4% to 6%. However, investors often look for ideal cap rates in the range of 8% to 12% to recover the investment more quickly. In the case of a 10% cap rate on a single-family home, this indicates the return of your investment within 10 years.
What is a Good Cap Rate on Investment Property?
Investors typically look for properties with a 5% to 10% cap rate. However, the market, property location, property type and other economic factors can all influence the ideal cap rate for a specific area and type of investment property. However, a 5% to 10% cap rate offers strong investment potential that balances returns and risk.
Factors That Can Influence Cap Rates
Factors that typically influence cap rates include location, demand and other economic factors. Here's how each factor affects the single percentage you see as the cap rate:
Property Location
The location of the property is a significant factor in determining the cap rate. Properties in prime locations with high demand, strong economic growth, desirable amenities and good transportation infrastructure tend to have lower cap rates due to higher property values and potential appreciation. Transitional or outlying neighborhoods will usually have a higher cap rate.
Property Type
Different property types have varying cap rates. Commercial properties like office buildings, retail centers or industrial warehouses often have different cap rates than residential properties like apartment complexes or single-family homes. The specific property type influences the risk profile, income potential and market dynamics, thus affecting the cap rate.
Market Conditions
Overall real estate market conditions are crucial in cap rate determination. Factors such as supply and demand dynamics, market trends, investor sentiment and economic indicators impact cap rates. In a competitive market with high demand and limited supply, cap rates tend to be lower whereas in a market with oversupply or weaker demand, cap rates may be higher.
Economic Factors
Economic factors like interest, inflation, employment and GDP growth can influence cap rates. Higher employment volatility, fluctuating demand, higher tenant turnover and leasing costs in these areas can all impact operating cash flow and lead to a higher cap rate.
Lower interest rates tend to push cap rates down as borrowing costs decrease and investors accept lower returns. Conversely, higher interest rates can increase cap rates as investors demand higher returns to compensate for increased borrowing costs.
Property Performance
The property's performance, including rental income, operating expenses, occupancy rates and lease terms, can impact the cap rate. Higher rental income and lower expenses result in a higher net operating income (NOI), which may lead to a lower cap rate. Factors like lease duration, tenant quality and rental growth potential influence the property's income stability and, consequently, the cap rate.
Optimizing Cap Rates
Understanding cap rates is a powerful tool for investors to assess a property's income-generating potential quickly. However, it doesn't replace deeper assessment of individual properties, understanding ROI for the investor or other financial analysis. Using the cap rate with deeper research and market understanding can help ensure successful real estate investing and strong financial growth. To get started, you can use Benzinga's cap rate calculator and net operating income calculator here.
Frequently Asked Questions
What is a low cap rate?
A low cap rate represents a property with lower risk but will take longer to recapture the initial investment. A cap rate is a mathematical relationship between net operating income divided by current market value. A low cap rate can mean higher operating income in relation to property value.
What is a normal cap rate?
Normal cap rates range from 3% to 12% or more. Ideal cap rates for investors usually range from 5% to 10%.
Is cap rate the same as ROI?
No, a cap rate is not the same as ROI, although they are connected. The cap rate is the expected return based on the property value, while ROI is the return on your cash investment and is not connected to the market value.