Whether you are a first-time investor or have been in the game for years, it’s important to understand returns. After all, most commercial property valuations take a cap rate into consideration. Read on to learn how to determine this value using our formula and easy-to-use cap rate calculator.
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What Is a Cap Rate?
Cap rate (or capitalization rate) is a way to measure profitability of an income-producing property. This simple formula tells real estate investors how much of their initial investment they can expect to get back each year.
Cap rates vary largely by property type, location, and class. However, the old adage of “high risk equals high reward” typically holds true in these calculations. CBRE compiled a great recap of average cap rates, and we’ve included some averages below:
- Multifamily: 5.26
- Industrial: 6.34
- Office: 6.71
- Retail: 7.5
- Hotel: 7.97
Calculating Cap Rates
The cap rate is the property’s annual net operating income (NOI) divided by the property’s current market value. The cap rate formula is simple:
Cap Rate = Net Operating Income / Property Value
It’s easiest to calculate this value manually. However, if you’re like me, math is not your strong suit. In this case, you can use a cap rate calculator to determine the return on an investment property.
You only need to know the net operating income and the value of the property to the cap rate calculation. With these numbers in hand, simply:
- Start with the property value, which is what you paid for the property, given you own it now. Or it could be the market value.
- Find net operating income (NOI) by first adding up all the monthly expenses. This includes items such as property taxes, property management, utilities, insurance and homeowner’s association fees.
- Now subtract the expenses from the monthly gross rental income. This gives you monthly NOI.
- Multiply NOI times 12 for the annual NOI.
- When you have the annual NOI and the property value, you divide NOI by the property valuation.
- This gives you the cap rate, which is expressed as a percentage.
Cap rate calculation example
For example, say you have a property you paid $100,000 for. The monthly rent is $1,000. The monthly cost of property taxes, management, utilities, insurance, and HOA fees is $400.
Subtracting $400 in expenses from $1,000 in monthly rent income gives you $600 in monthly NOI. Multiplying monthly NOI of $600 times 12 gives $7,200 as annual NOI. If you divide $7,200 by the $100,000 you paid, the answer is 7.2. So the cap rate on this property is 7.2%.
You can add estimates for minor repairs to the expenses to give a more realistic figure. You can also improve accuracy by accounting for vacancies. Online calculators such as this one make including vacancy rate easy.
Note: Cap rate figures are for operating income. That means it doesn’t include income taxes or mortgage payments for interest and principal.
Calculate Your Own Cap Rate
Using Omni’s cap rate calculator, you can easily find your own return. Simply enter the variables as prompted and you’ll see your cap rate automatically appear before your eyes. We hope it’s a big number!
Why Cap Rate Is Important
Cap rate is used for a number of purposes in real estate investment. Valuing individual properties is one of the main uses. We’ve highlighted the main reasons for using a cap rate calculator below:
Determining relative valuation
You can use cap rate to see if a property is being offered for sale at a fair price. You can also use it to help you decide how to price a property you are selling. In either case, do some research to find out what the cap factor is for similar properties of that type in that real estate market.
A real estate broker should be able to provide this information. Say a property is being offered at $200,000 and will produce monthly rent of $2,000. You estimate operating expenses at $650 per month.
That means NOI is $2,000 minus $650 times 12 or $16,200. At a sale price of $200,000, the cap rate on this property is 12.35%.
Verifying return claims
Say your broker tells you the cap rate for this type of property in this market is 10%. Since this property indicates a higher cap that suggests this is a deal worth looking at more closely.
You can do the same thing in reverse to suggest a selling price for a property you are unloading. You can also find out cap rates from appraisers and commercial services such as RealtyRates.com.
Guiding purchase decisions
Because a cap rate can suggest what kind of return a given property will generate you can use it to choose between investments. All things being equal, the property with the higher cap rate will be a more profitable investment.
Evaluating overall markets
You can use cap rate to evaluate how healthy a market is. Lower cap rates indicate a stronger market where properties are in high demand. Major cities usually have higher cap rates than smaller markets.
Determining lending limits
Cap rates are used by rental income investors, but they are also used by appraisers when placing a value on a rental property. This is done by dividing the NOI by the cap rate.
For example, say a property has a cap rate of 10% and a NOI of $10,000. The value of this property will be $100,000. As cap rates decrease, prices increase. If the cap rate was 5%, the value would increase to $200,000.
Cap Rate Factors to Consider
Because cap rates don’t include income tax or debt service, it doesn’t tell the whole story on an investment. It just tells you how much you can expect to earn before income taxes and payments against loan principal and interest.
Also, unless you’re including vacancies in the way you calculate cap rate, it won’t account for that factor. This can be significant in high-turnover rental properties such as student apartment complexes.
As noted, cap rates are also location dependent. A cap rate in Houston could be very different from a cap rate in a small market like Wichita Falls, Texas. Cap rates may also vary by sub-market. Returns in Dallas suburbs will likely be quite different from cap rates in downtown Dallas.
Cap rates are also dependent the class and condition of the property. A new high-rise luxury apartment building will have one cap rate. A garden apartment complex built decades ago that has a lot of deferred maintenance will have another.
External factors matter as well. Overall residential cap rates in the U.S. fell to very low levels just before the 2008 housing market collapse. In that case, cap rates were driven down by low interest rates and easy credit to ultimately create a speculative bubble.
Cap Rate Alternatives
Using a cap rate is a simple way to measure a complex business. So most real estate investors consider it only as one tool for evaluating investments. Some of the other tools available to investors include:
- Cash on cash return is another useful way to look at real estate investments. This adds debt service costs to the operating costs. Then it divides the result by the cash invested in the property. Cash on cash is a good way to evaluate a property that is being financed.
- Return on investment is another option to cap rate. It takes into consideration the reduction in principal caused by making loan payments. ROI is the ratio of the cash after debt service plus principal reduction to invested capital.
- Debt service coverage ratio (DSCR) is another measure. It compares the NOI to the required debt payments. To figure it, divide NOI by the loan payments.
- Gross rent multiplier is a ratio of the price to the income the investment will generate. To figure it, divide the purchase price or market value of the property by the gross annual income. This is simpler than the cap rate. It only looks at income instead of also accounting for expenses as the cap rate does. However, it can be a quick screen when looking a large number of properties.
Limits of Cap Rates
Long-term rental investors often use the cap rate to compare and screen investments. House flippers don’t usually calculate cap rate, however. Rental investors who only expect to own properties for a short time also probably won’t use cap rate.
Cap rates are also of limited use when a situation is complicated and will change a lot over time. For instance, say you have purchased a multifamily property and plan to make significant upgrades in stages over a long period. A cap rate won’t help you much there.
Different cap rates may also be due to factors that re hard to see. A property may have a high cap rate compared to other market properties. But that could be because it has serious issues.
For these reasons, savvy investors rarely use cap rates alone to make investment decisions. It’s a screening tool and one among several assessment methods that can help identify good investments.
What Is a Good Cap Rate?
By now the question of what a good cap rate might is probably front and center. The short answer is: anything above 7% is an excellent cap rate in many markets. Typically, cap rate in any given market will fall between 5% and 7%. Of course, these factors vary based on location, property class, and market cycle.
Assuming a 7% rate can help with quick screening. If a property has a higher cap rate than that, for instance, you may want it investigate further. Cap rates are a basic measurement of a real estate investment’s profitability. Understanding how to figure it and when to use it is a basic skill for real estate investing.