Cap rate, short for capitalization rate, is one way that real estate investors can value investment properties. The cap rate tells you the potential annual return of a property, based on your expected rental income and operating expenses set against the property’s value. A high cap rate means that the property is giving a high rate of return compared to the property’s value, while a low cap rate suggests the opposite.
How to Calculate Cap Rate
The most common way to calculate a property’s cap rate is to divide net operating income by the fair market value of the property, where net operating income is rental and other income subtracted by operating expenses and allowances for vacancy and credit losses. Another way is to divide net operating income by the property’s purchase price. A cap rate calculator can be used to easily determine your net operating income and cap rate.
The key difference between these two versions is that the first method uses the value of the property, while the second method uses the cost of the property. The cost of the property would be used if you are looking to purchase the property.
Valuing Real Estate Using the Cap Rate
A real estate investor might use the cap rate calculated using the property’s purchase price to determine if the property will have an acceptable cap rate. The cap rate can also be used to determine the value of a property. This allows an investor to determine if the property is undervalued or overvalued. Investors can also compare between different investment properties by using the cap rate.
To determine the value of a property using the cap rate, divide the property’s expected net operating income by the cap rate. This gives the value of the property.
For example, let’s say that a property has a cap rate of 6% and annual net operating income of $12,000. The property value would be ($12,000 / 6%) = $200,000. Based on the net operating income and cap rate, the property is valued at $200,000. If the asking price of the property is higher than $200,000, you will need to consider if a lower cap rate would still be acceptable. Let’s say that the purchase price would be $300,000. This means that the cap rate would be ($12,000 / $300,000) = 4%. If you require your investment to have a cap rate of at least 6%, then you wouldn’t invest more than $200,000 in this property.
A minimum required annual return through the cap rate can allow you to make better buying decisions by allowing you to calculate the maximum amount of money that you would be willing to pay. If the annual return is the only criteria when choosing between properties, then you can easily filter through properties with less than stellar returns.
Sometimes, you might not necessarily know a property’s cap rate. This might be the case for new properties that haven’t generated any revenue yet. In order to value these new properties, you could use the cap rate of comparable properties. This means using the cap rate of nearby properties that are in the same property class.
What is a Good Cap Rate?
Now that you know a property’s cap rate and value, what makes a good investment? On its own, the cap rate won’t tell you much. You’ll need to consider factors such as location, property type, and total investment required to determine if a property would be a good investment.
CBRE’s U.S. Cap Rate 2021 Survey provides a look at average cap rates in 25 markets based on property type. Hotels and offices had some of the highest cap rates depending on the city, while industrial and multi-family properties had the lowest cap rates. This reflects the risk of investing in these property types. Hotels and offices have had higher average cap rates in 2021 to compensate for their higher risk.
Cap rates can range significantly not just between property types, but also between cities. For example, the average cap rate of downtown hotels in Chicago ranged between 8% to 10% in 2021, while the cap rate of hotels in downtown Seattle ranged between 6.25% to 7%. A cap rate of 7% for a hotel in Seattle might be acceptable, while a cap rate of 7% in Chicago might mean that you’re overpaying for the property.
A high cap rate can represent a good investment opportunity, or it may just reflect the higher risk that the property has. Your risk appetite also plays a role when choosing between properties.
Summary
A property’s cap rate can be calculated if you know its net operating income. Once you know the property’s cap rate, you can use the cap rate to value an investment property and determine whether it would be an acceptable return for you. You can also compare between properties using the cap rate. In some cases, you might not know a property’s exact cap rate. You can use the average cap rate in the market that the property is located in or use the cap rates of comparable properties. The cap rate lets you know the return and value of a property, and allows you to compare it with your own investment goals and risk profile to determine if a specific property would be a good investment for you.
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