Cap rates are an excellent tool for assessing a property’s overall profitability. Although it may be difficult to pinpoint a perfect cap rate, there are ways investors can determine if the cap rate of a property meets their individual investment goals. Read on to see how investors can make the most out of their investments using cap rate calculations.
What Is a Cap Rate?
Cap rates can provide helpful information about any property by estimating the expected rate of return on commercial or residential real estate. They are estimates of the rates of return on numerous commercial or residential real estate properties. These rates are computed by dividing the property’s net operating income (NOI) by the asset value of the property.
Cap Rate = NOI / Current Market Value
A property’s cap rate is defined by its potential revenue and risk level compared to other properties. It is important to note that the cap rate will not provide a complete return on investment. It will instead offer an approximation of how long it will take to recover the initial investment in the property.
The most widely used benchmark for comparing investment properties is the cap rate.
Good vs. Bad Cap Rates
A “good” cap rate varies depending on the investor and the property. Generally, the higher the cap rate, the higher the risk and return. Market analysts say an ideal cap rate is between five and 10 percent; the exact number will depend on the property type and location. In comparison, a cap rate lower than five percent denotes lesser risk but a more extended period to recover an investment.
Investors should spend some time thinking about a reasonable cap rate for the properties in their portfolio. Utilizing the cap rate formula can help investors immediately eliminate properties that don’t fit their risk threshold by having a desired rate in mind.
What Affects a Property’s Cap Rate?
According to J.P. Morgan Investment Banking, Cap rates usually reflect more prominent economic factors. These factors include:
- Interest rates – High inflation and the ensuing increases in interest rates can impact commercial real estate cap rates; when interest rates rise, cap rates quickly follow suit.
- Rent growth – When there is a prevalent expectation of higher rents and NOI, this can lead to a noticeable increase in interest rates. A declining economy can also put pressure on cap rates to rise and halt rent growth.
- GDP and unemployment – GDP and unemployment both indicate the state of the economy. Commercial real estate investments tend to have lower cap rates when GDP is high and unemployment is low. Investment properties carry a higher risk when GDP is low and unemployment is high.
- Location – Cap rates are influenced by the location’s vicinity to highways, public transportation, popular city locations, etc. Properties in a stable location in an area with high demand typically have lower cap rates.
How to Utilize Tools To Value Property
The cap rate of a property is not the only metric used to assess a real estate investment. Investors should examine the return on investment (ROI), internal rate of return (IRR), and gross rent multiplier (GRM), as well as several other considerations, such as the property’s unique attributes and location.
What Is Cap Rate Compression?
Cap rate compression refers to growing market prices for investments concerning the income generated by the investment. In summary, cap rates are inversely connected to market pricing; hence, when cap rates are compressed, prices rise without a corresponding increase in rental income. According to supply and demand rules, cap rate compression may come from excessive investor demand or a general lack of quality inventory, resulting in higher pricing for the same assets.
Cap rate compression is largely indicative of market recovery. Location, sector shift, and economic environment are three factors that have historically driven cap rate compression.
Takeaway
Cap rates are forward-looking, and each transaction is influenced by a building’s potential, the investor’s perspective regarding the property, and the current economic conditions and expectations.
FAQs
To calculate cap rate, follow this formula: (Gross income – expenses = net income) / purchase price * 100. Cap rates between 4% and 12% are generally considered good, but it's important to remember that other factors, such as potential improvements, should also be considered when evaluating a property.
What's a good cap rate for rental property? ›
Average cap rates range from 4% to 10%. Generally, the higher the cap rate, the higher the risk. A cap rate above 7% may be perceived as a riskier investment, whereas a cap rate below 5% may be seen as a safer bet. If a property has a 10% cap rate, you should expect to recover your investment in about 10 years.
What is the 2% rule for cap rates? ›
What Is the Cap Rate 2% Rule? If you look around the internet, you'll see that the 2% rule means commercial properties with monthly rent of 2% of the purchase price. You're going to have a difficult time finding these properties that have a gross yield over 20% per year.
What does a 7% cap rate mean in real estate? ›
The cap rate is an asset's unlevered (no mortgage) return, and a reflection of an asset's relative risk. If the buyer were to purchase the property all cash in the example above, and if the property distributes the same net operating income, the buyer would receive a 7% return on their investment.
Do investors want high cap rate? ›
It indicates that a lower value cap rate corresponds to better valuation and a better prospect of returns with a lower level of risk. On the other hand, a higher value of cap rate implies relatively lower prospects of return on property investment, and hence a higher level of risk.
What is a good ROI on rental property? ›
In general, a good ROI on rental properties is between 5-10% which compares to the average investment return from stocks.
Is cap rate the same as ROI? ›
Is Cap Rate Same as ROI? Cap rate and ROI are not the same. The cap rate is the expected return based on the property value, but the ROI is the return on your cash investment, not the market value.
What is the Airbnb cap rate? ›
An Airbnb cap rate is a metric to evaluate the attractiveness of an investment, and can be applied to a potential STR property. It is the ratio of the property's net annual rental operating income to its purchase price.
Is a lower cap rate better? ›
It's generally better to have a lower cap rate than a higher one. A lower cap rate implies that the property is more valuable and less risky due to type, class, and market. While a higher cap rate offers investors a higher return, that property investment typically has a higher risk profile.
What is a cap rate for dummies? ›
Capitalization rate: Net operating income divided by the sales price. Also known as the cap rate, it is the measure of profitability of an investment.
The disadvantage of using the cap rate for evaluating an income property is that it is challenging determine the cap rate value for a sold property due to the dif culty of determining a sold property's operating expenses.
Do cap rates go down when interest rates rise? ›
Rising interest rates increase the cost of capital, so fluctuations in the interest rate environment can contribute to rising cap rates. That's the case in the current economic environment. The Fed's interest rate hikes increased financing costs, limiting transaction volume and making it difficult to assess cap rates.
Should cap rate be higher than mortgage rate? ›
The cap rate 2% rule is a simple guide that some real estate investors follow to decide if a property is worth exploring. It says that the property's cap rate should be about 2% higher than the current mortgage rate.
Is 20% cap rate good? ›
A “good” cap rate varies depending on the investor and the property. Generally, the higher the cap rate, the higher the risk and return. Market analysts say an ideal cap rate is between five and 10 percent; the exact number will depend on the property type and location.
What is the 2% rule in real estate? ›
Definition of the 2% Rule
For example, if a property costs $200,000, it should bring in at least $4,000 per month in rent ($200,000 x 0.02 = $4,000) for the 2% rule to be satisfied. The idea is that properties meeting this threshold are more likely to bring positive cash flow and provide good returns.
Is a 7.5 cap rate good? ›
Whether a 7.5% cap rate is good depends on your investment goals, current interest rates, and risk tolerance. When interest rates are lower than cap rates, the property's potential for cash flow is higher.
What is the 50% rule? ›
The 50% rule advises investors to estimate a property's operating expenses will amount to roughly half of its gross income. While this estimation proves helpful in projecting rental property cash flow, it is not a flawless measurement and should only ever be used as a starting point for further research and analysis.
