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
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 considered a good cap rate on rental property? ›
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 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.
What is the cap rate 2% rule? ›
The 2% rule states that the expected monthly rental income should equal or exceed 2% of the purchase price. Using the same example, a $200,000 rental property should generate a monthly rental income of at least $4,000.
Do investors want high cap rate? ›
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 the 50% rule in real estate? ›
The 50% rule or 50 rule in real estate says that half of the gross income generated by a rental property should be allocated to operating expenses when determining profitability. The rule is designed to help investors avoid the mistake of underestimating expenses and overestimating profits.
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 cap rate the 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 a cap rate for dummies? ›
The cap rate is defined as the ratio between the net operating income (NOI) produced by an asset and its market value, thus constituting the rate at which the NOI is capitalized to derive the price of the asset.
Does cap rate include expenses? ›
For real estate investments, Cap Rates are calculated by dividing your Net Operating Income (NOI), or Rent minus Expenses, by the market value of a property. Your expenses include everything except mortgage payments.
That said, many analysts consider a "good" cap rate to be around 5% to 10%, while a 4% cap rate indicates lower risk but a longer timeline to recoup an investment.1 There are also other factors to consider, like the features of a local property market, and it is important not to rely on cap rate or any other single ...
What is the 4 3 2 1 rule in real estate? ›
Analyzing the 4-3-2-1 Rule in Real Estate
This rule outlines the ideal financial outcomes for a rental property. It suggests that for every rental property, investors should aim for a minimum of 4 properties to achieve financial stability, 3 of those properties should be debt-free, generating consistent income.
What is the 1 rule in property investment? ›
For a potential investment to pass the 1% rule, its monthly rent must equal at least 1% of the purchase price. If you want to buy an investment property, the 1% rule can be a helpful tool for finding the right property to achieve your investment goals.
What is a good ROI for rental property? ›
In general, a good ROI on rental properties is between 5-10% which compares to the average investment return from stocks. However, there are plenty of factors that affect ROI. A higher ROI often also comes with higher risks, so it's important to compare the reward with the risks.
What are the disadvantages of cap rate? ›
It doesn't account for debt: The cap rate doesn't take into account the impact of debt on an investment property. If the property is financed with a mortgage, the cap rate doesn't account for the interest payments or the impact of leverage on the return.
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.
Is a 12% cap rate good? ›
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. Cap rate does not account for changes in cash flow due to improvements or renovations, and it does not consider leverage.
Is 8.5 cap rate good? ›
Good cap rates for Class B properties in the different markets might be: Tier I market cap rates between 6.75 – 7.5% Tier II market cap rates between 7 – 8% Tier III market cap rates of 8-10%
