Capitalization rates, or cap rates, are used by real estate investors to determine whether an investment property is a worthwhile buy based on its potential return on investment (ROI). A cap rate is calculated using the formula below, expressed as a percentage, since it is based on annual returns. As a result, if a property performed well or poorly for one year, the cap rate would reflect that.
An example of how NOI is calculated is as follows: You have $60K in gross rental income, 85% occupancy rate, and $15,000 in operating expenses.
$60,000 x 85% = $51,000
$51,000 – $15,000 = $36,000 NOI
The formula for calculating net operating income:
NOI = Rental income + Other income – Vacancy losses – Total operating expenses
Cap Rate Examples
Here are two cap rate calculations for two different properties. The more expensive property isn't necessarily going to have a higher cap rate.
Property A
Property value: $850,000
NOI: $56,080
Property B
Property value: $700,000
NOI: $48,560
Calculate the cap rate by dividing the NOI by the property value
Property A: $56,080 / $850,000 = 0.066
Property B: $48,560 / $700,000 = 0.069
Because the cap rate formula is expressed as a percentage, multiply now by 100:
Property A: 0.066 x 100 = 6.6% cap rate
Property B: 0.069 x 100 = 6.9% cap rate
Property B is less expensive but has a higher cap rate, making it a better buy. This is why you should consider the overall financial picture of the investment property before buying, including ROI, cash flow, and what comparable properties are selling and renting for.
What Is a Good Cap Rate?
Generally, a cap rate over 4% indicates a good investment property and will result in a higher financial yield. A cap rate below 4% may mean a lower return on investment, and you may want to consider another investment property.
It is also important to note, however, that a lower cap rate means the investment is safer or less risky, while a higher cap rate means riskier. Before buying a new investment property, it is crucial to understand how cap rates work and alternative calculations to evaluate financial potential.
Factors That Affect the Cap Rate and When To Use the Cap Rate
Investors who buy property for rental purposes commonly use the cap rate. Commercial and residential landlords and investors will also evaluate a property based on the cap rate.
Use the cap rate for
Single-family investment properties
Condo and townhome rental properties
Commercial real estate investments
Multifamily rental properties
Apartment buildings
Evaluating property landlords own before selling
When Not To Use the Cap Rate
The cap rate calculation does not work for every investor. If you are fixing and flipping or buying vacant land, you will not rent out the property, so you won't be affected by the cap rate.
Generally, you won't consider the cap rate in the following scenarios:
If you fix and flip a property, you sell it for profit once it's fixed, so you don't consider rental revenue potential.
You can't calculate rental income or NOI on vacant land, so the cap rate does not apply. Please read our guide to buying land before purchasing vacant land.
Buying a vacation rental property: The cap rate won't accurately reflect the value since the property may not be rented year-round.
A short-term rental property is likely to have a skewed cap rate because it is rented only for a short period, and the cap rate is calculated based on annual income.
Alternative Ways To Evaluate Investment Property
In addition to the methods mentioned above, there are other ways to evaluate investment properties. Consult your financial advisor and consider multiple metrics for property performance.
To determine the value of a potential property, compare the sales prices of comparable properties in the area.
Calculate the per-unit price by multiplying the potential purchase price by the number of profitable units in the building.
Calculate cash flow by subtracting expenses such as mortgage payments, taxes, insurance, and utilities from rental income.
If the gross rental yield exceeds 7%, the total property cost, including purchase, closing, and renovation costs, should be divided by the annual rent collected and multiplied by 100.
The property usually has a positive cash flow when gross monthly income is at least one percent of the purchase price.
A real estate investment with more than 10% ROI is considered good. Divide your annual return by your total cash investment.
Bottom Line
To determine if an investment or commercial property is a good investment, calculate the potential cap rate of the property. When purchasing real estate, the cap rate should not be the only factor to consider. Schedule a call today, and we will find the best investment that works for your needs.