What does cap rate mean in real estate? How’s it calculated?

This is no secret that real estate investors, whether experienced or new, seek profitable investment opportunities. What helps them identify such properties is good research on metrics such as capitalization rate aka cap rate, beyond their familiarity with market dynamism. So, what does cap rate mean in real estate? Well, it’s a metric that property investors use for property evaluation and deal identification. 

In this blog, we’ll understand what cap rates are, what they signify, and how are they computed.

What does cap rate mean in real estate?

The capitalization rate, or cap rate, is a key tool in real estate investment. The cap rate is a common way to evaluate real estate investments for profitability and return potential. It shows the property’s yield over one year if bought with cash, or without a loan. Simply put, it shows the expected rate of return (ROR) on a property. 

The cap rate is calculated by dividing the property’s net operating income by its value and is expressed as a percentage. This rate helps investors gauge potential returns and determine the property’s selling rate in the future. It significantly impacts investment decisions. 

But, be cautioned: While cap rate is useful for comparing similar investments, it shouldn’t be the sole factor for assessing investment strength. That’s because it doesn’t consider leverage, time value of money, or future cash flows from property enhancements.

Keep in mind that a higher cap rate indicates greater investment risk, while a lower cap rate suggests lower risk for property investment. 

How is capitalization or cap rate calculated?

The capitalization rate for real estate investments is commonly computed using two formulas.

The popular cap rate formula divides the property’s net operating income (NOI) by its current market value:

Capitalization rate = NOI / Current property market value 

The net operating income represents the annual income generated by the property after deducting all management expenses such as upkeep and property taxes.

And, the current market value is the present-day value of the property according to market rates.

Another formula calculates the capitalization rate based on the property’s original capital or acquisition cost:

Capitalization rate = NOI / Sale price

However, this second version is less popular for two main reasons. Firstly, it yields unrealistic results for older properties purchased at low prices. Secondly, it doesn’t consider the case of inherited properties as there is no purchase price for such real estate.

What is a good example to answer, what does cap rate mean in real estate?

Let’s consider a scenario where Alex possesses $1.5 million and he invests in a commercial real estate housing multiple tenants expected to pay regular rent.

Let’s say the total annual rental income amounts to $100,000, with $25,000 allocated for home maintenance costs and property taxes. This yields a net income of $75,000 from the property investment. Suppose during the initial year, the property maintains its original purchase value of $1.5 million.

The capitalization rate (net operating income/property value) will be 5% ($75,000/$1.5 million).

Often, such a return outperforms the standard return from risk-free Treasury Bonds. 

How does the cap rate vary?

Several market factors such as income levels, property expenses, property age, property type, and market valuation significantly influence the capitalization rate. Location, particularly in high-traffic areas, often leads to higher rates of return for commercial properties.

You also have to consider the local market’s characteristics, including competing properties. Typically, well-developed markets feature lower capitalization rates due to competitive pressures.

Furthermore, future trends such as market growth can impact a property’s long-term capitalization rate. For instance, fluctuations in interest rates can affect cap rates due to their influence on borrowing costs.

What’s more, the capital invested in a property can influence its cap rate. And of course, renovations enhancing a property’s appeal may raise rental value and boost operating income for the owner. However, vice versa is also true. A property owner may lose rental income due to various factors. For instance, if some tenants move out and the rental income decreases. Or, if the rental income remains the same but maintenance and property tax expenses increase. Or, if the market value of the property drops.

What is considered a good cap rate on a piece of property?

As mentioned, cap rates exhibit high variance. Determining the “ideal” capitalization rate varies, and investors should assess their risk tolerance. Generally, a high cap rate suggests higher risk. On the other hand, a low cap rate indicates lower returns with lower risk.

Many property analysts view an ideal cap rate as falling between 4% to 10%. However, the specific figure hinges on the property’s location, condition, and the rate of return necessary to justify the investment.

It also depends on the type of property. A cap rate ranging from 8% to 10% may be deemed favorable for a rental property while a cap rate of 6% to 7% might be regarded as favorable for a multifamily property situated in a high-demand market.

It’s crucial to consider additional factors, such as local property market features, and not solely rely on the cap rate or any single metric when assessing a property. 

The cap rate also reflects the time required to recover the invested amount in a property. For instance, a property with a 10% cap rate will take approximately 10 years to recover the investment.

The bottom line is that there are no definitive ranges for good or bad cap rates; they depend largely on the property and market context. Two similar properties located in different parts of the same city can have very different cap rates. 

For instance, a city center property will likely yield higher rent than one on the outskirts of a city. However, it will be offset by increased maintenance costs and taxes. Consequently, it will have a lower cap rate due to its higher market value.

Read more: What is mills in real estate?

Is there a limitation to considering only cap rates for real estate investment?

The capitalization rate is a good indicator for properties with consistent income streams but may need to be more dependable for those with irregular cash flows. It overlooks future risks such as depreciation or market shifts that could disrupt cash flows. Investors must consider these risks when they calculate cap rates. Therefore, the cap rate cannot be the sole measure of investment property returns.

Last thoughts

If you are contemplating a property investment, you must examine comparable properties to evaluate the cap rate of a property, taking into account variables such as property type, location, income, expenses, quality, condition, and durability. Together, these elements shape an investor’s risk and return assessments. These can guide your choices in real estate investments.

Written by Ramona Sinha. July 18, 2024

Ramona is the Senior Content Writer for Kukun. This experienced blogger uses simple and succinct words to decipher the complex phenomenon called life. She has written articles covering a broad range of topics, such as real estate, lending and mortgage, finance, business, taxation, home designs, home improvement projects, decor concepts, and more. An avid traveler, she’s a digital nomad at heart and an animal lover from the depth of her soul.