A cap rate, otherwise known as a capitalization rate, is one of the most important fundamental indicators for determining whether or not a property is worth pursuing. Not surprisingly, cap rates have proven instrumental in building some of today’s most prolific real estate investing portfolios, and there’s no reason it couldn’t help you do the same. In fact, I’d argue that you can’t even build a halfway decent portfolio without asking, “what is a good cap rate?” It’s that important. Therefore, it’s in your best interest to not only gain a better understanding of what a cap rate is, but also how to use it to strengthen your investing efforts.
Cap rate is one of the easiest and most dependable ways to quantify whether or not an investment deal is worth following through with. In its simplest form, a cap rate is nothing more than an equation; one that will identify how much an investor stands to make or lose if they end up buying the property in question. It is worth noting however, that a cap rate won’t provide investors with the exact amount they stand to gain, but rather an estimate. Cap rates are no more accurate than stock market predictions; they are subject to an inherent degree of error, and should be taken with a grain of salt. I repeat, cap rates are not 100% accurate; they are merely used to estimate one’s potential return on their investment. That said, a properly estimated cap rate is invaluable when supported with due diligence and an acute attention to detail.
Cap rates are not intended to act alone; and should instead be used in conjunction with other metrics. A cap rate by itself is almost useless, but a cap rate with supplemental data and information can significantly mitigate the amount of risk an investor will be exposed to over the course of an investment. Therein lies the benefit of learning how to calculate cap rate: the resulting number can mitigate more risk than many investors realize. If you know how much an investment could potentially make, it stands to reason you’ll know whether or not you should pull the trigger on the purchase.
Cap rate is used by investors who are deciding whether or not to move forward with a given property. In some cases it may also be used by investors preparing to sell a property. Cap rate works best for rental properties and may not be as helpful in other scenarios. For example, investors should avoid relying on cap rate when evaluating raw land, fix and flip properties, and, in some cases, short term rentals. This is because the cap rate formula relies on annual net operating income which would not be applicable in these cases. Investors (or even landlords) can, however, use cap rate when evaluating a number of property types including:
Cap rate is important because it can provide a look at the initial yield of an investment property. The formula puts net operating income in relation to the purchase price of the investment, which can put the potential profitability of the deal in perspective for investors. According to Investopedia, the cap rate can also reveal the number of years it will take to recover the initial investment. For example, a property with a 4 percent cap rate will take four years to recover the investment. Overall, cap rate is an important way for investors to estimate the level of risk associated with a given property.
(Net Operating Income / Current Market Value) X 100 = Capitalization Rate
For as important as cap rates are, they aren’t as complicated to calculate as you would assume. In fact, learning how to calculate cap rate requires nothing more than basic math skills or a free cap rate calculator. Although, before you start calculating your own cap rate, you’ll need two things:
It is worth pointing out that calculating a property’s market cap is contingent on gathering accurate information. Therefore, you will need to mind due diligence and make absolutely certain that you can pinpoint the net operating income. To do so, estimate the annual revenue of the rental property (using rental income) and then subtract the total operating expenses. For more information on how to accurately estimate net operating income, be sure to read this article.
The main difference between cap rate and ROI is what the two metrics are used for. As I have already alluded to, a cap rate is used to estimate the investor’s potential return on investment (ROI). That said, it’s not hard to see why many entrepreneurs confuse the the two. On the surface, the two metrics are very similar; they each tell an investor what to expect if they move forward with an investment. It is worth noting, however, that cap rate and ROI serve a different purpose when analyzing a deal.
Return on investment is meant to give investors an objective percentage on how much they can expect to make on a deal. For example, ROI is typically expressed as a percentage, as to estimate the investor’s potential return on his or her investment. That way, investors can compare the ROIs of two completely different assets. The return on investment expressed as a percentage make it easier to compare two individual assets, whether or not they are the same. Investors can, therefore, compare the ROI of a three month rehab with a 30 year buy and hold.
The cap rate, on the other hand, is used to compare similar real estate assets. For example, a cap rate would be perfect for someone to compare returns from two rental properties, but far from ideal for investors who want to compare a rental property to a rehab.
A good cap rate hovers around four percent; however, it is important to differentiate between a “good” cap rate and a “safe” cap rate. The formula itself puts net operating income in relation with initial purchase price. Investors hoping for deals with a lower purchase price may therefore want a high cap rate. Following this logic, a cap rate between four and ten percent may be considered a “good” investment.
However, capitalization rates have also become synonymous with risk evaluation. In order to determine a “safe” cap rate you must identify how much risk you are comfortable exposing yourself to. Essentially, a lower cap rate implies lower risk, while a higher cap rate implies higher risk. Investors hoping for a safer option would therefore favor properties with lower cap rates. The most important thing to remember is that you should never take on more risk than you are comfortable with, ad you should always use cap rate in addition to other calculations.
An investment property cap rate may sound simple, but its implications are heavily weighted. That’s why its crucial to expand your real estate education and ask questions like “what is a good cap rate?” After all, those who equip themselves with the best tools for investing—like cap rates—stand a better chance at realizing success in the industry.