In the world of real estate, the definition of cap rate isa metric used to estimate the potential ROI (return on investment) on a commercial property by dividing the net operating income by the current property value or projected purchase price.
Now, let’s try to rephrase the cap rate definition to make it a bit easier to understand. Don’t worry; by the end of this article, you’ll know everything you need to know about real estate cap rates.
The cap rate (short for capitalization rate) helps a real estate investor estimate the potential returns on their investment in a piece of commercial real estate. When you divide the net operating income (the total rental income minus the non-mortgage expenses) by the current property value or projected purchase price, you get a percentage that indicates the current return potential.
The cap rate is like a risk and reward indicator. A higher cap rate indicates higher risk and higher potential reward. A lower cap rate indicates lower risk and lower potential reward.
Cap rates are not used in residential investing; they’re only used in commercial investing. But, if you’re deciding between investing in commercial or residential real estate, remember that residential buildings with more than four units are considered commercial property, not residential property.
Cap Rate Formula
Now, let’s take a look at how to calculate a cap rate.
We’ll start with the mathematical formula, then we’ll break it down into individual elements and give examples.
The cap rate formula is:
Net operating income (NOI) / market value or purchase price = cap rate
We need to know three figures for this formula:
The total operating expenses (excluding any mortgage payments; mortgage debt is not factored into the cap rate),
The total rental income,
And the market value or purchase price of the property.
When you subtract the total operating expenses (outside of any mortgage payments) from the total rental income, you get the NOI. That takes care of the first part of the formula.
Now, how do we get the current market value?
You can get the market value in a few different ways:
If the property was recently purchased, you can use the purchase price. As long as the property was purchased on the open market by a willing buyer and seller, the price the parties agreed to is a solid indicator of the property’s value.
If there is a recent appraisal on the property, you can use that value.
You can calculate the market value yourself (or have a real estate expert do it for you). Calculating the fair market value of real estate is a complex process. In most cases, the “comparable sales” approach to value is the most appropriate. This involves searching market data for recent sales of properties similar to your subject property. You then adjust the sales prices of those comparable properties (comps) to estimate what those properties would have sold for if they had been identical to your subject (same location, size, condition, etc.). This tells you how much the property would sell for on the open market today, which is the market value.
Example of How to Calculate a Cap Rate
Let’s say you just purchased a rental property, a fully occupied 5-unit apartment building in Los Angeles, for $2,000,000. The annual cash flow of rental income is $180,000. And the annual property expenses are $36,000. This includes expenses like landscaping, maintenance, insurance, and property taxes. And remember, the principal and interest from any mortgage are excluded from the property expenses.
The NOI would be $144,000 (180,000 - 36,000). And we can use the recent purchase price of $2,000,000 as the market value.
So, to calculate the cap rate, we divide 144,000 by 2,000,000, and we get .072. Then, when we convert that to a percentage, we have 7.2%. This 7.2% is our cap rate.
What is a Good Capitalization Rate?
A “good” cap rate depends on several factors including
Property type,
Location,
And risk tolerance.
In very general terms, most investment experts agree that the ideal cap rate range is 4-10%. Lower than 4%, you’re probably playing it too safe, not taking enough risk to enjoy reasonable returns. Higher than 10%, and you might be taking on too much risk.
Is a higher or lower capitalization rate better?
It depends on your risk tolerance. If you’re okay taking some risk, look for cap rates closer to 10%. If you’re looking to avoid risk, stick closer to 4%.
You might be wondering how much risk could be involved. Is real estate low risk? Generally, yes, real estate is considered to be low risk. But the risk amount can vary from one property to the next. High expense commercial properties like hotels, for example, are generally riskier than small, mid-range apartment buildings. Those hotels will likely have a higher cap rate than the small multi-family building.
How is Capitalization Rate Different from Return on Investment?
Cap rate and ROI are similar but different. They both measure return potential. Cap rates are excellent for quickly comparing one asset against another to see which has the better potential. ROI is better for determining the actual return you receive for every dollar you invest over time. ROI takes your down payment into consideration, while cap rate calculations do not.
Gordon Model Representation for Cap Rate
A cap rate isn’t only for commercial real estate. It’s also used when considering a stock market investment decision.
The Gordon Growth Model (GGM), which is also called the dividend discount model (DDM), calculates the value of a company’s stock price, independent of the current market conditions, using the present value of a stock's future dividends.
Since this article focuses on real estate cap rates, we won’t get into detail on the Gordon Model. But for anyone wondering, the Gordon Model cap rate calculation is:
Stock Value = Expected Annual Dividend Cash Flow / (Investor's Required Cap Rate - Expected Dividend Growth Rate)
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