What is the likelihood of a real estate investment being profitable? Many investors ponder this question and use metrics like the cap rate to determine their odds. Knowing the cap rate can help you assess the potential risks and rewards before investing significant capital into a property. Performing these calculations by hand can be difficult, but our cap rate calculator makes the entire process easy. Quickly calculate the cap rate on any real estate investment property.
Cap Rate Calculator
What is a Cap Rate?
Simply put, cap rates measure how much of the original capital invested to buy a property will be returned to the owner each year. A property's cap rate is represented as a percentage of how much cash (or capital) flows through to the owner on a yearly basis after expenses in relation to the purchase price of the property.
Understanding Cap Rates in Real Estate
Although it's not as highly publicized as home flipping, multifamily and commercial real estate have been the savvy investor's preferred option in the real estate asset class for decades. In addition to the opportunity to flip buildings for profit, multifamily and commercial properties can generate revenue streams for their owners through rental income.
This income is known as cash flow because the cash paid in rent by tenants flows to the owner. With that said, all commercial and multifamily real estate isn't created equally. Cash flow is only part of the equation.
An income property's cash flow before operating expenses, which is also known as gross revenue, is important but not nearly as important as how much of the cash actually gets to the owner after expenses like property taxes and maintenance. Because of this, investors often rely on a figure known as a capitalization rate or cap rate in property valuations to determine whether a particular property is a good investment.
What are Cap Rates Used for?
A higher cap rate indicates a property can generate more profits but may come with extra risk. Some investors are willing to incur the extra risk in exchange for higher profits. Aside from their importance to investors, the cap rate is also incredibly important to lenders when assessing whether or not to finance a given property. There is no federal mortgage insurance for multifamily and income-producing commercial real estate, which means the lender will inevitably be left holding the bag if the owner defaults.
The fact that properties with lower cap rates also generate less annual income can raise the likelihood of default because investors will have lower reserves to absorb costly contingencies such as major repairs or multiple tenant defaults. This increased risk translates to higher interest rates and down payments for investors looking to secure financing for properties with low cap rates.
Investment analysts can use cap rates for one or more similar properties in a given area to assess market trends that may provide insight as to when to buy or sell. For example, a building with a low cap rate in what should be a hot market might reveal an undiscovered gem that's just waiting to be scooped up and polished off by a forward-thinking investor. By contrast, a building with a high cap rate in a relatively cool market might be indicative of an upward swing on the horizon.
Lastly, cap rates play an important role in the valuation of a property. A lower property valuation relative to income will have a higher cap rate, and a higher property value will have a lower cap rate.
Cap Rate Calculation
A property's capitalization rate can be calculated by taking the following steps:
- Calculate the property's net operating income (NOI) by deducting annual operating expenses from annual gross revenue.
- Divide the property's NOI by the purchase price for the property.
For example, the cap rate on a property with an NOI of $75,000 and a purchase price of $1 million would be calculated as follows:
$75,000 NOI ÷ $1 million purchase price = 7.5% cap rate
Using Market Cap to Determine Property Value
Aside from being strong indicators of a property's overall health, market cap rates are an important tool in property valuations. In fact, it's possible to estimate a property's current market value by using a market cap rate.
The market cap rate is based on the rate of return investors require on a specific type of property in a certain area. This can be influenced based on risk and the current demand in the market, similar to many other types of income investments.
As discussed above, a cap rate is calculated by dividing its net operating income by the purchase price. Therefore, it is also possible to calculate a property's value by dividing a property's net operating income by the market cap rate.
For example, the valuation of a property with a net operating income of $75,000 where the market is saying a fair cap rate is 7.5% would be calculated as follows:
$75,000 NOI ÷ 7.5% cap rate = $1 million property value
What is a Good Cap Rate?
Several factors determine whether a cap rate is good. First, there is the age-old key to real estate: location. Remember, the purchase price of a property is an important part of the cap rate calculation. The location of a given property as well as its asset class are key factors in determining the purchase price. This also means geography and the type of property being sold both play huge roles in determining what a good cap rate is.
For example, a luxury apartment building in Soho, N.Y., will have a high purchase price, and even though the rents are high, the cap rate will be affected by the price. So, if the building costs $5 million with a net operating income of $300,000, the cap rate would be 6%.
On the other side of the equation, a $1 million building in Dayton, Ohio, might have a cap rate of 10% and generate $100,000 per year in net operating income. However, there may not be nearly as much ability to increase rents at the building in Dayton, which means both the cap rate and the building's value are going to be relatively stable for as long as the investor owns the property.
Every investor has a different philosophy. Some prefer the upside of buildings in high-end markets while others prefer the stability of mid-grade buildings in more affordable cities. That is why the question of what a good cap rate is takes into account several different factors. A partial list of these factors includes:
- Location of the property
- Price of property
- Type of property (e.g. residential or commercial property)
- Investor risk tolerance
- Potential upside (e.g. likelihood of increase in rents or NOI)
How a Change in Net Income Affects Cap Rate
Cap rates are affected by a property's net operating income - how much money it generates for the owner after all expenses are accounted for. A number of different factors can affect a property's NOI from one year to the next.
Chief among these factors are overall economic conditions - is it a booming market or a recession - and whether there is an abundance of supply in the market, which pushes down rents. Whenever these factors manifest themselves, the property's NOI changes. This, of course, changes the capitalization rate.
Imagine the $5 million Soho property referenced above has a great year where the owner can push rents to the max, and the building's net operating income would increase from $300,000 to $420,000. Using the cap rate formula of dividing the NOI by the purchase price, the Soho building would increase from a 5% cap rate to a 7% cap rate that year. This is a tremendous increase, and even though the cap rate would rise only 2%, the owner's revenue would increase by nearly 50% over the previous year. This is why even a 1% increase or decrease in net operating income can have a huge effect on a property's cap rate.
What Else Affects Cap Rates?
Higher cap rates increase the potential ROI of a property. Changes in net income affect the cap rate, but that's not the only component. A number of factors can impact cap rates, and property owners and investors control several of those factors.
They can renovate and upgrade a property, which should theoretically result in higher rents and raise the cap rate by raising the property's NOI. More effective and proactive management also can bring maintenance costs under control. A simple change of property management companies can lead to increased NOI and a corresponding change in cap rate.
However, external factors such as geography and market conditions are almost entirely out of an investor's control. These factors must be considered just as thoroughly as cap rates in assessing whether to invest in a property.
Other Real Estate Valuation Formulas
Although the cap rate calculation method is the preferred method of calculating property value and investment analysis, there are several other formulas investors use in evaluating potential acquisitions. Examples of those formulas are listed below:
- Cash on cash return: The amount of actual cash returned to the investor after all property expenses and debt payments
- Internal rate of return (IRR): Projections of what the investor hopes to sell the property for combined with the amount of the original investment and the property's net income into a formula to derive a percentage of anticipated profit
- Debt service coverage ratio (DSCR): Net operating income divided by its total annual debt service (mortgage plus insurance payments for a year) to determine the ratio of income generated by the property in relation to the debt service
Incorporating Cap Rates into Your Investment Strategy
Cap rates are an incredibly important piece of information in property valuations, lending and investment analysis. But when it comes to cap rates, beauty is in the eye of the beholder. One investor might look at a property with a low cap rate and run for the hills while another may look at the same property and see a glorious opportunity.
The more proficient investors become at understanding cap rates and the factors that influence them, the better decisions they can make when they invest in real estate.
Frequently Asked Questions
What is a good cap rate?
A good cap rate depends on the location, but many investors look for cap rates between 5%-10%.
What is a bad cap rate?
As a general rule of thumb, a cap rate below 5% limits the potential gains but also indicates the property is in a less risky area.
Can a cap rate be too high?
A higher cap rate means more risk. Not every real estate investor wants to make high-risk investments. These investors would benefit from staying away from properties with cap rates above 10%.
Is cap rate and ROI the same?
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