What Is Cap Rate?
Capitalization rate, also called cap rate, is the rate of return that an investor can expect to earn on a real estate investment property. Commercial real estate investors use it to determine how long it will take to recoup their investment in a property. Many investors will roughly calculate this number mentally, before doing further diligence on a potential investment.
In its simplest form, investors determine the cap rate of a property by dividing the property’s annual net operating income by the value of the asset. The resulting number is a percentage, and it’s how investors understand the potential return on a property. Essentially, the cap rate represents the financial returns of a property over a single year.
What Does a Cap Rate Indicate?
The ranges of what constitutes a good or bad cap rate varies widely, depending on the investment property and its market. Investors use the cap rate as a quick guide to an investment’s value compared to other similar real estate investments.
But as an indicator, the cap rate leaves out important aspects of a real estate investment such as the leverage undertaken to purchase and develop a property, and the time it will take to realize cash flows from improvements.
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The Formula for Calculating Cap Rates
The most popular formula for calculating cap rates is this:
• Capitalization Rate = Net Operating Income / Current Market Value
Here’s a breakdown of each of those components in this context:
Net Operating Income
Net operating income consists of the property’s gross annual income — all the rent and other revenues the property produces — minus all of the common home repair costs, taxes, insurance, and other expenses related to the property, excluding mortgage payments. Once those costs have been subtracted from the income, you have the net operating income.
Current Market Value
Current market value isn’t necessarily the price that an investor paid for the property. Rather, it’s the price that the property would sell for today. In the case of a prospective real estate investment, it’s the price that the investor would pay to buy a property.
Cap Rate
When an investor divides the Net Operating Income by the Current Market Value, they take the number that’s left and move the decimal point two digits to the right to arrive at the cap rate. That number represents the percentage return investors can expect from the property.
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How to Calculate Cap Rate
Cap Rate Example
An investor who’s considering a real estate investment would start by finding out the annual rental income it produces. This is easier to do with an existing property that already has paying tenants because it has a track record and leases in place.
Assuming that an investor is interested in a property that already has tenants, an investor can ask for this information from the current owners. For instance, in this hypothetical investment, an investor finds out from the present owners that a property has tenants who pay $90,000 a year in rent.
But the building costs $9,000 per year to manage. It also costs $4,500 to maintain the property. Then there’s another $7,100 that the owner of the building will have to pay in property taxes. Finally, insuring the building will cost $6,500 per year.
To arrive at the net income of the property, the investor will have to subtract all of those annual expenses from the property’s gross annual income. In this example, the net income of the property, after factoring all of those costs, comes in at $62,900.
Once an investor knows the net income that the property produces, they divide that number by the current market value (if they already own the property), or the purchase price (if they’re thinking of buying it). In our example, if the current market value/purchase price is $400,000 and the net income is $62,900, the formula gives a result of 0.15725. And when the investor moves the decimal point two digits to the right, the result is 15.72. That number — 15.72 — tells the investor that they can expect the property to deliver an annual return of 15.72%.
Using a Property’s Cap Rate
While a property’s past income can serve as a guide, cap rates are based on projected estimates of its future expenses and future income. As the business climate and the condition of the property fluctuate from year to year, the property’s cap rate will also fluctuate.
But even though the cap rate changes over time, it is a valuable way to understand the real value of an investment, simply because it tells an investor how long it will take to recoup their investment in the property. For example, an investor purchasing a property with a cap rate of 10% will need roughly 10 years to earn back the initial investment.
After that 10-year investment, the investor will still own the property and be entitled to the net income. But before they reach that point, many unexpected risks related to property investing can rear up and derail the investor’s plans.
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The Limitations of Cap Rate
The cap rate of a property is a projection, and nothing more. Investors purchasing a Treasury bond paying 3% have every reason to expect that if they hold it to maturity, they’ll receive 3% annually.
But property investing comes with a host of risks that can keep that rosy cap rate from ever becoming a reality. With commercial real estate, the most likely risk is that the tenants will move out.
To go back to our example, if a third of the tenants move out of the building, then its gross income will go down to $60,000. But the building’s many expenses will most likely remain steady, making its net income $32,900. Assuming that the building’s value hasn’t changed, suddenly its cap rate is $60,000/$400,000, or 8.2%.
There are also factors having to do with the property itself. Even when well maintained, buildings break down and wear out over time. That adds to the operating costs and diminishes the net income of the property. It also affects the value of the underlying asset that the investor owns.
Some risk factors that investors should consider include the age, location, and condition of the property. At the same time, investors should think about what type of property they’re buying — whether it’s a single or multifamily home, industrial, office, or retail property. They should also consider how the type of property could be affected by outside influences. For instance, retail and hotel owners saw their cap rates fall significantly when the coronavirus pandemic reduced business for their industry.
There are also unknowns, such as inflation, which could make some of the investor’s expenses higher but also potentially allow them to increase the rent. Digging deeper, investors buying an established property may want to do some homework on the current tenants’ financial status, as well as their history of paying rent on time.
Investors should also look at the terms of the current leases that they’ll be inheriting when they take over the property. At the same time, investors should take a larger view of the macroeconomic factors affecting the property, its location, and its tenants, and consider the potential opportunity costs associated with tying up a portion of their portfolio in an investment property.
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The Takeaway
The cap rate formula provides investors with a valuable measure when evaluating the opportunity presented by a property investment. Cap rate can help them gauge how long it might take to recoup their investment.
But cap rate is just one measure investors should look at when considering a property. The age, location, and condition of the property are important, as is the current lease situation. Potential real estate investors should do thorough research.
That said, overall, real estate investment may be one way to diversify a portfolio, since real estate returns typically do not correlate to the returns of stocks and bonds.
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