What Is The Cap Rate And Why Is It Important?

In the world of real estate, the cap rate is a very important and essential metric.

Using the cap rate, an investor can evaluate an investment property, helping them determine if it is a good investment or not.

However, figuring out cap rates and being able to calculate them is not very straight forward.

That's why, in this guide, we will be going over all aspects of cap rate, including examples on how to calculate it and how it can be used to evaluate potential properties.

To begin, let's get into the specifics of what cap rate is and why it's useful.

What Is Cap Rate?

The capitalization rate, or cap rate, is used in real estate to give an estimate of the rate of return that is expected from a real estate investment. This means that this measure is capable of estimating an investor's potential return on residential or commercial real estate investments.

Now, although this sounds like a metric that will allow investors to make perfect investment choices and always get a positive return on your initial investment, that's not true. This metric is only an estimate of the potential return on investment for a specific property.

To estimate this, the cap rate formula uses various metrics like:

• Property's net operating income
• Market size
• Operating expenses
• Current property asset value
• Asset stability

...and more.

This all sounds useful, but, how is it really useful?

In the next section, we will be discussing why cap rates are useful and how to interpret them to help determine your next investments.

Understanding Cap Rates

Since cap rates are based on so many factors, they are subject to a high amount of variance and variability. For this reason, it is important to understand all aspects of the cap rate, especially knowing what constitutes a good cap rate.

One way to think about the cap rate intuitively is by having it represent the percentage return an investor would potentially receive on an all cash purchase. This means that, if the cap rate comes out to around 5%, the investor would receive an annual return of around 5% on the investment property.

Another way that the cap rate can be interpreted is that it is also the amount of time that it will take to recover from the investment. Using the same example from above, an investor who invests in a rental property with a cap rate of 5% will take about 5 years to recover from the investment.

Apart from understanding why cap rate is useful, it is also important to understand when the cap rate is useful. Below, we have outlined some different situations where the cap rate is and is not useful.

When Is The Cap Rate Useful

Calculating the cap rate can be useful in a plethora of different situations. One of the most common situations where the cap rate should be calculated is when an investor is interested in a property that is going to produce regular, consistent income.

For example, if an investor is interested in investing in a multi-unit property that they are planning on filling with tenants, it will be important to calculate the cap rate. This is because the investor will want to have a rough idea of the rental income that will be produced by that property.

When Is The Cap Rate Not Useful

For some investors, calculating the capitalization rate is not very useful. This is mostly the case when the investor is interested in using the rental property as a vacation or short-term rental property. It is also not very useful if the investor is simply interested in flipping the property for a profit.

When the investor is interested in these kinds of investments, things like the net operating income and capitalization rates are not very useful. Instead, the investor will be looking at things like:

• Property value
• Current market value
• Property taxes

...and other metrics that are more immediate for the investor.

Pitfalls Of Cap Rates

As mentioned before, it is important to remember that cap rates are not definitive measurements and should not be taken as one.

In a situation where the investment property has irregular or inconsistent cash flows, the cap rate can be extremely misleading. This is because the capitalization rate depends on regular and consistent cash flow.

For investment properties with these characteristics, a discounted cash flow model will be better for measuring the potential return on the investment. This is because the cash flow model takes into account things like depreciation and structural changes while the cap rate does not.

So, to better understand whether a cap rate is useful for you, you should be well versed on the various things that affect the cap rate, which are discussed below.

What Affects The Cap Rate?

There are a multitude of different factors that can affect the cap rate of an investment property. Below, we will discuss some of the most important factors that affect the cap rate of an investment property.

1. Property Type

The six main property types include:

• Residential
• Commercial
• Agricultural
• Industrial
• Mixed-used
• Special purpose

These property types are then divided even further based on more specific characteristics.

The property type is important because it plays a huge role in determining the risks, expenses, potential net income, and much more. Since these are all factors that real estate investors consider when calculating cap rates, it's important to know them well.

2. Property Value

One of the most important factors when calculating cap rates is knowing how the property fits into the market at that specific time. For example, real estate located in packed cities tends to have higher cap rates compared to similar properties in smaller cities or towns.

This is a very important distinction, as it is not referring to the specific price tag of the property. Here, we are referring to the relative value compared to the surrounding real estate market.

3. Rental Potential

A property's value and property type may determine the potential income that it will generate but they do not determine whether or not tenants will be interested in the property.

This is why it is so important to consider the rental potential of the property. This means looking at things like vacancy rate, turnover rate, and other metrics that may dictate if tenants will be attracted to the property.

So, now that we know all about capitalization rates and why they are important, let's get into the different ways that they can be calculated.

Calculating The Cap Rate

To calculate the cap rate, real estate investors typically use one general formula:

In this formula, two important metrics are being used, the net operating income (NOI) and the current fair market value. It is very important to know how to calculate these other metrics to be able to calculate the cap rate.

Below, we have outlined basic methods for calculating both of these metrics.

Net Operating Income

The net operating income is essentially the gross rental income minus the total operating expenses.

To calculate the gross rental income, you can simply multiply the total monthly rent by 12. However, if the property is not rented, you can multiply the going rent for similar buildings by 12.

To estimate operating expenses, real estate investors have to consider all kinds of expenses, including:

• Real estate taxes
• Insurance
• Maintenance
• Utilities (if not paid by tenant)

...and potentially many more.

By subtracting these two measurements, you can easily calculate a property's net operating income.

Current Fair Market Value

The current fair market value can either be the current asking price or the price that the investor is willing to offer.

This is very easily determined by simply looking at similar properties in the area and using some of those numbers. Or, the investor can use the property's actual listing price as the current fair market value.

Important Considerations

One important consideration that real estate investors should always keep in mind is that the cap rate formula shown above assumes 100% occupancy rate throughout the year.

This may sound normal for single family homes but this can be a rare occurrence in multi-unit establishments. So, in these cases, it is a better idea to slightly adjust the formula to the one shown below:

This variation of the cap rate formula uses the same metrics as the previous one but also includes the occupancy rate. The occupancy rate is typically underestimated to account for potential losses of rent.

Calculation Examples

In this section, we'll be explaining two different examples of how to calculate the cap rate, one using the traditional formula and one using the occupancy rate formula.

Without Occupancy Rate

Let's say a real estate investor is considering a $450,000, three bedroom home. After speaking to the property manager, they find out that the current tenants pay $2,500 a month in rent. This means that the gross rental income is $24,000.

The property manager also explains that the property has roughly $6,500 in annual operating expenses. This means that that net operating income comes out to: $17,500.

To then calculate the cap rate, you divide the net operating income by the property's current fair market value to get the cap rate, which would be 3.8%.

With Occupancy Rate

For the sake of simplicity, we will be using the same example from above, where the price of the home is $450,000 and the annual operating expenses come out to $6,500.

However, the property manager now tells you that the property only has about 90% occupancy rate. To account for that, you have to multiply the gross rental income with the occupancy rate to get a revised gross rental income.

This means that the new net operating income will come out to $15,100. Using this new metric, the cap rate comes out to around 3.4%, making this investment slightly less attractive.