By:

Sophia Merton

Updated

February 8, 2022

With inflation higher than it has been in decades, many people are looking for a way to ensure that their money is working for them, not against them. One classic hedge against inflation is investing in rental properties. A critical aspect of understanding rental properties is the concept of a "cap rate."

When you’re buying your first investment property, you might find yourself overwhelmed by the deluge of advice you can find on the internet when it comes to evaluating a property. On top of that, there are countless complex financial concepts that you’ll want to grasp before diving in.

One of the most common ways that investors measure the potential of a property is with its cap rate. This is actually a fairly simple formula that can help you estimate the annual rate of return you’ll receive from the property.

What is a capitalization rate, exactly? How and when should you use this metric in property investment? Let’s take a look at everything you need to know.

The **definition of a cap rate** is the expected rate of return that the property will produce from the investor's initial investment in the first year.

The capitalization rate, or cap rate for short, is a crucial property metric for real estate investors. When you are searching for your next investment, you can use the cap rate as an evaluative tool for prospective properties. When you determine the cap rate of a property, you are estimating the rate of return you would generate if you made the investment.

When you take the expected net operating income of a property and divide it by the current market value or the purchase price, you are left with a percentage. This is your cap rate.

A cap rate is used to help estimate the rate of return on real estate properties. This is a useful way to compare various properties to help you determine which property best suits your investment needs and strategy. In general, a higher cap rate means a better return, assuming the same amount of risks and needed repairs. The higher the cap rate, the faster the potential investment will return your invested money.

This doesn't mean you should only buy extremely high-cap rate properties. Sometimes, a cap rate is high for a reason - additional risks and/or deferred expenses.

The cap rate is not a metric that gives you an exact figure in terms of your total return on investment. However, it does give you a ballpark figure of how long it will take to break even on the initial investment.

The formula for calculating a cap rate is quite simple. Let’s take a look at the three steps you need to take to find out the cap rate of a prospective property.

**1. Calculate The Property’s Net Operating Income**

The first step in the process is determining the net operating income (NOI) of the property. Simply put, this number is the amount of money that the property brings in after you subtract its associated expenses.

The income streams of a property might include rent, onsite amenities that are available for an extra cost, and additional fees.

Once you had calculated the gross income from the property, it’s time to add up your expected expenses. These will include insurance, taxes, maintenance and repairs, and legal fees.

You will want to make sure you are factoring in every possible expense as a part of this equation. Consider the cost of property management if you’ll be using it, repairs, and utilities if you plan to include them in the rent.

It’s important to also account for vacancies as an expense. After all, you’ll still be paying the monthly expenses of the property whether or not you’ve found tenants.

You can either use the commonly assumed 10% vacancy average or you can do more thorough research into the typical vacancy rates in your location.

Once you have added up all of your anticipated income streams and expenses from the property, you can subtract the latter from the former. This number is your NOI.

For example, if your expected income amounts to $6,000 a month and your expected expenses amount to $1,000 a month, your NOI is $5,000 per month or $60,000 per year.

**2. Divide By The Current Market Value/Purchase Price**

Now you will take your NOI and divide it by the current market value of the property. Another method is to use the purchase price rather than the current market value.

You can determine the current market value in a few different ways, including using home valuation tools available online or conducting a comparative market analysis (CMA).

If the NOI for the property is $60,000 per year and the current market value is $500,000, for example, you would divide 60,000 by 500,000. This leaves you with 0.12.

**3. Convert Into A Percentage**

Finally, you will take the product of the NOI divided by the current market value and convert it into a percentage. All you have to do is multiply the product by 100. In the above example, multiplying the product of 0.12 by 100 leaves you with a cap rate of 12%.

It’s worth understanding that there are a variety of factors that can impact the cap rate of a property. Let’s take a look at some of the factors you’ll want to be considerate of.

- Location

The location of a property is a major factor that can influence its cap rate. There is often a correlation between a higher risk of success and a higher capitalization rate.

- Market Size

If you’re considering a property in a small market that isn’t particularly competitive, you might find the cap rate is higher. On the flip side, you might find that an investment property in a large, competitive market has a lower, more appealing cap rate.

- Asset Stability

Another factor that can play a role in the cap rate of a property is how stable you expect the property value to be. The more uncertain the projected property value, the higher you might find the cap rate.

- Potential for Growth

Are you looking for a property in a market that is growing quickly? If so, this can have an impact on the cap rate.

Capital Liquidity. Lastly, a major factor that influences a cap rate is how much money you expect to put into the investment property. This is because your NOI will be directly influenced by how much capital you invest upfront.

The cap rate of a property is only one of the ways you can evaluate prospective investments. If you are planning on flipping a property right away or you expect the property will have irregular income streams, another metric should be used.

If you are planning on flipping a house, it’s better to use the valuation method known as the after repair value (ARV). The pro forma cap rate is a good metric for properties you want to rehab and then rent out.

If you are preparing to purchase a rental property, you will also want to determine the price to income ratio, the gross rental yield, cash flow, and a number of other vital metrics.

When interest rates rise, a number of different things happen in the world of real estate investing. For example, both the cost of debt and the cost of equity increase.

While there is quite a bit of debate about to what extent cap rates rise with interest rates, investors generally agree that cap rates go up when interest rates go up. If interest rates rise and cap rates rise with them, this causes asset values to decline if all else is equal.

Average cap rates have been moving steadily downward for several years now, but some experts expect that will change in the near future. This is potentially due to both rising interest rates as well as the outlook towards the risk premium.

On the flip side, both the cost of debt and the cost of equity decrease when interest rates fall. Cap rates generally fall when interest rates go down, however, they won’t necessarily decrease at a 1:1 correlation.

Rather than looking at a cap rate as a universal metric to tell you whether or not to purchase a property, it’s better to use it as a personal assessment tool in relation to your risk tolerance, comfort level, and real estate investment strategy.

In general, though, a higher cap rate indicates that an investment is riskier. You can use this number to estimate how long it will take for you to recover your upfront investment.

For example, a 4% cap rate indicates that it will take about four years to break even, while an 8% cap rate indicates that it will take about eight years.

While we’ve largely discussed cap rates being used as a metric to evaluate properties before purchasing, capitalization rates are also useful if you are planning on refinancing at any point in the future.

The cap rate of a property helps to quantify the cash flow a real estate investment produces or is expected to produce. Depending on how your property has performed since you took out the initial loan, you might be able to use this metric to help argue your case if you want to refinance for better rates.

The cap rate of a property is also sometimes referred to as the actual cap rate or the purchase cap rate.

While this can be a useful metric if you’re buying a property without any deferred maintenance issues, it’s missing important information if you’re hoping to fix-and-flip property or utilize the BRRRR method.

Basically, the actual cap rate of a property won’t take into account the rehab costs of a property. If rehabbing a property is a part of your investment plan, a pro forma cap rate can be a more appropriate tool.

With a pro forma cap rate, you take the net operating income of the property and divide it by the total acquisition cost. Your total acquisition cost is calculated by adding the purchase price and the anticipated cost of the rehab. The product of this formula is your pro forma cap rate.

This is a useful tool when you want to estimate the return on your initial investment including the cost of rehab. It can be difficult to estimate how much it will cost to rehab a property, particularly because the same disclosure rules of residential real estate don’t apply to commercial real estate properties. However, it’s worth doing your due diligence in this regard, as you’ll want to have a fairly accurate assessment of your upfront investment.

Understanding the definition of capitalization rate is critical for investing in real estate. Not only does it require that you look closely at both the expected income and expenses of a property, but it also helps to quantify how much risk you’re taking on.

Running the numbers is essential when you’re choosing an investment property. For instance, you might find that an apartment complex that looks like the perfect addition to your portfolio actually isn’t all it's cracked up to be when you do your due diligence.

Our rental property calculator can help you make the right choice when it comes to purchasing a rental property. On top of that, it’s a great way to verify or disprove your assumptions about a piece of real estate. Head over to our calculator to gain a wealth of knowledge about a potential property’s prospects.

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Written By:

Sophia Merton

Sophia received her BA from Vassar College and is a real estate investor and researcher. With more than ten years of experience owning and managing investment properties, she has gained valuable insight into the pros and cons of operating rentals. Sophia is dedicated to helping others create wealth through real estate and aims to provide straightforward information about every aspect of rental property ownership.

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