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
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 the cap rate 2% rule? ›
Following the 2% rule, an investor can expect to realize a gross yield from a rental property if the monthly rent is at least 2% of the purchase price. To calculate the 2% rule for a rental property you need to know the property's price. You could then take that number and multiply it by 0.02.
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.
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.
Is 20% cap rate good? ›
As previously discussed, the higher the cap rate, the better the investment. A cap rate of 10% or higher is generally considered good, while a cap rate of 5% or lower is not ideal. Investors can use the cap rate to compare the potential profitability of different rental properties.
What is the 50% rule in rental property? ›
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 a realistic cap rate in real estate? ›
Average cap rates range from 4% to 10%. Generally, the higher the cap rate, the higher the risk. A cap rate above 7% may be perceived as a riskier investment, whereas a cap rate below 5% may be seen as a safer bet. If a property has a 10% cap rate, you should expect to recover your investment in about 10 years.
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 the Airbnb cap rate? ›
If you own an Airbnb, cap rate is a top metric by which to measure your STR's profitability and return potential, independent of that property's financing method. Because Airbnb cap rate is tied to your return on investment (ROI), you might think that high cap rates are ideal. But cap rates are also a measure of risk.
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.
A: It depends on the investor, the local market, and your expectations of future value appreciation. Some real estate investors are happy with a safe and predictable CoC return of 7% – 10%, while others will only consider a property with a cash-on-cash return of at least 15%.
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.
Is a 10% cap rate possible? ›
Cap rates vary widely depending on the asset class being valued and the market conditions where the asset is located. Cap rates usually sit between 3%-10%, but a good cap rate is based more on risk tolerance for a specific investment.
What cap rate is too low? ›
In real estate, a low (less than 5%) cap rate often reflects a lower risk profile, whereas a higher cap rate (greater than 7%) is often considered a riskier investment. Whether an investor deems a cap rate “good” is a direct reflection of whether or not they think the investment's return matches its perceived risk.
Is a mortgage included in the cap rate? ›
Does a cap rate include mortgage? No, the cap rate calculation does not include your mortgage payments. The formula for calculating cap rate includes your annual net operating income, minus annual expenses other than your mortgage. (Then, you'll divide that number by the home price to get your cap rate.)
How does the 2% rule work? ›
The 2% rule is an investing strategy where an investor risks no more than 2% of their available capital on any single trade. To apply the 2% rule, an investor must first determine their available capital, taking into account any future fees or commissions that may arise from trading.
Is the 2 rule in real estate realistic? ›
While the 2% rule can be a good starting point, it's really just the tip of the iceberg in determining whether a rental property is a good investment. It's also important to look at how much money you'll invest upfront and on an ongoing basis in order to get a better sense of how much profit you're likely to realize.
What is the 2 percent rule in investing? ›
One popular method is the 2% Rule, which means you never put more than 2% of your account equity at risk (Table 1). For example, if you are trading a $50,000 account, and you choose a risk management stop loss of 2%, you could risk up to $1,000 on any given trade.
What is a good cap rate for a 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.
