What is Capitalization Rate?
The capitalization rate (or cap rate, for short) is used in real estate to measure the expected rate of return on an investment property.
Real estate investors use the capitalization rate to help determine if they should buy a property. It helps them to make sure they’re getting a good deal. They calculate the cap rate using the annual net operating income (NOI) of the property and its current market value. The NOI is gross income (before anything is deducted) minus expenses. The NOI can increase when you make improvements to the property. The market rate tends to be influenced by outside factors, such as the state of the economy and increased or decreased demand in a given neighborhood. A higher capitalization rate is more favorable, but a “good” capitalization rate varies across different types of properties. You can use cap rate for single-family investment properties, condos and townhomes, multifamily rental properties, apartment buildings, and commercial real estate.
Let’s say an investor is considering buying one of two different rental properties. Property A has a value of $500,000, a gross rental income of $75,000, and operating expenses of $25,000. By using the cap rate formula — Capitalization Rate = Net Operating Income / Current Market Value — we can determine that property A has a cap rate of 0.1 or 10%.
Property B also has a value of 500,000, but it has a gross rental income of $85,000 and operating expenses of $45,000. Using the cap rate formula, we can determine that Property B has a cap rate of 0.08 or 8%.
Our investor would look at these numbers and conclude that Property A is likely to return his investment more quickly than Property B.
A capitalization rate is like a crystal ball for investors...
It may not be spot on 100% of the time, but it gives you a glimpse into the future and tells you how quickly you’ll be able to see a return on your real estate investment.
You can calculate cap rate by using the net operating income of the property (NOI) and its current market value. That formula looks like this:
Capitalization Rate = Net Operating Income / Current Market Value
You can calculate NOI by subtracting the annual expenses from the gross annual income. The gross income would consist of the money generated from rent, while the expenses would include all costs associated with managing and maintaining the property. These costs would include regular maintenance and repairs, administrative costs, and property taxes.
The market at the time determines the property’s current market value. Sites like Zillow have calculators to tell you the median home value and rental prices in your area.
As for estimating your annual expenses, there’s a popular rule, known as the 1% rule, that says you should plan to spend 1% of the purchase price each year for regular maintenance costs. So if you buy a property for $250,000, this rule would say you should plan to spend around $2,500 per year on maintenance (though other factors go into this such as the age and condition of the property).
We’ll talk later about what a “good” cap rate is, but for now, let’s talk a little bit about how you can interpret the cap rate of a property.
As we said, the cap rate measures the expected rate of return for a property.
Let’s say you’re considering investing in real estate and determine that the cap rate for the property you’re looking at is 10%.
If the market value, income, and expenses of the property were to all remain steady, you would earn back 10% of your investment per year. And over 10 years, you would have recovered your entire initial investment.
Keep in mind that this calculation leaves out a lot of information.
First, it assumes that you’ll always have consistent income from the property, meaning it will never be vacant. It also assumes you’ll never have higher expenses than the property has now. Finally, it assumes the market value of the property won’t change over the course of 10 years. You can’t control the market, meaning this factor is out of your hands.
So now that we know what cap rate is and how to calculate it, what is a good cap rate? The short answer is: It depends. Several different factors can play into whether a cap rate is “good.” You can expect a reasonable cap rate to fall somewhere between 4% and 10%, according to a 2019 survey by the real estate investment firm Coldwell Banker Richard Ellis (CBRE).
A general rule of thumb is that, as with many other investments, the higher the risk, the higher the potential reward. As such, properties with a higher cap rate also tend to have a higher risk associated with them.
A good practice would be to look at the average cap rate for your area, and if you see a property has a cap rate far higher than average, you might want to find out why that is. Maybe it’s a building that has a high cap rate if it’s fully occupied, but occupancy is inconsistent. Or maybe it’s a building that has a high cap rate for the past year but turns out to have a lot of deferred maintenance needed.
Cap rates vary depending on the type of property you’re talking about, and it’s something to keep in mind as you weigh your investment decisions.
Apartment buildings tend to have lower cap rates than commercial retail properties because commercial buildings tend to have higher rents.
But in this situation, the cap rate doesn’t tell the whole story.
Even though the cap rates tend to be lower with multifamily residential properties, the risk is also a lot lower for a couple of reasons.
First of all, an apartment building with lots of tenants means that if one tenant doesn’t pay their rent, you’re only out a small percentage of your income. But if you own a single commercial retail building and the tenant doesn’t pay their rent, you’re out all your income.
Multifamily residential properties are also more consistent when the economy dips. Regardless of other financial factors, most people will always find a way to pay rent, so that they have somewhere to live.
But if the economy takes a turn for the worse and a retail tenant isn’t getting business, they’re more likely to close up shop, meaning you may lose that income.
So your potential return on your investment might be higher with a commercial property, but the risk is also higher.
Location is also a factor in determining what an acceptable cap rate is. If you live in an area where rental prices are high, but home prices are low, you should expect to see higher cap rates and vise versa.
Properties in low-population areas may have a higher risk associated with them because the demand for housing isn’t as high. That might mean going longer periods between tenants.
In New York, good housing is in high demand. So even though the cap rate might be lower (meaning the income is lower compared to the value of the property), your risk is lower because it’s likely there’s always going to be someone willing to live there.
Real estate investors sometimes use the 1% rule to determine if the monthly rent earned from an investment property will be enough to cover the monthly mortgage payment for the property.
You can calculate your rough expected maintenance costs under the 1% rule by multiplying the purchase price of a property (plus any necessary repairs) by .01 (1%). This formula gives you a baseline for what you should be charging for rent.
As an investor, you would also want to make sure that your monthly mortgage payments don’t exceed the number you end up with from that calculation.
For example, let’s say you’re buying a residential rental property for $200,000, and you plan to invest $50,000 in repairs, bringing your total investment to $250,000. When you plug that number into the 1% rule formula, you end up with $2,500. That means that you would want to make sure your monthly mortgage payments don’t exceed $2,500 and that you’re charging at least $2,500 for rent.
The 1% rule is a rough guide; you will want to fully evaluate the potential costs and pitfalls of any investment property.
Both cap rate and return on investment (ROI) are important tools for investors to help them evaluate potential rental properties. And while the terms are sometimes confused or used interchangeably, they represent two different things.
The cap rate is a calculation of the operating income in relation to the market value of the property. ROI is a calculation of the return you receive in relation to your initial investment (either the cost of the property if you paid in cash or the cost of your downpayment if you took out a mortgage).
Unlike the cap rate calculation, ROI takes into account your actual upfront investment into the property, as well as any debt you’ve taken on. For example, let’s say you purchase a rental property. Your actual expenses for the purchase and upkeep are $150,000. Over the course of the next year, you collect $12,000 in rent from your tenants ($1,000 per month). Divide your annual return of $12,000 by your expenses of $150,000, and you end up with .08, or an ROI of 8%.
Cap rate is best used for buy-and-hold investors (those who buy an investment and hold it for a long period of time). In contrast, ROI is useful for both buy-and-hold investors as well as fix-and-flip investors (short term investors who buy real estate to renovate and sell for a profit).
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