- In real estate, capitalization rates (cap rates) measure estimated rates of return for income-producing properties such as commercial buildings, industrial spaces, and residential multi-family units.
- Cap rates are calculated by dividing a property's net operating income (NOI) by its current market value.
- Real estate investors often use cap rates to compare multiple investment opportunities so they can choose the opportunity that fits their risk and reward preferences.
As a real estate investor, you rely on profitability metrics to make informed decisions regarding which properties to purchase and when. For investment properties that generate stable income, such as commercial buildings or multi-family developments, capitalization rates (cap rates) are a critical measurement of profitability.
Cap rates can be used to quickly compare one investment opportunity against another, allowing you to confidently choose between multiple options.
This article will define cap rates, explain how cap rates are calculated, and show you how to interpret cap rates.
What Is a Cap Rate?
A cap rate is a profitability measurement used to assess the potential rate of return for an income-generating investment property.
Cap rates reflect the net operating income (NOI) of a property as a percentage of the property’s value. This rate of return is for a single year of operations and does not consider the financial impact of any loans on the property or any change in future cash flows based on future improvements.
Why Cap Rates Are Important in Real Estate Investing
Cap rates are essential in real estate investing because they help investors evaluate potential returns, compare properties, and assess investment risks.
Cap rates are often used to compare the relative value of multiple properties, particularly those in the same area or market segment, so an investor can decide between multiple opportunities. A higher cap rate typically indicates higher risks and potential rewards, while a lower cap rate suggests lower risks and potential rewards.
While cap rates are an important measurement, they are not the only tool for calculating rates of returns. Before deciding on a commercial real estate investment, investors should
consider a range of profitability metrics, including return on investment (ROI), internal rate of return (IRR), and gross rent multiplier (GRM) in addition to cap rates.
When To Use Cap Rates (and When Not To)
Cap rates are best used for properties with a history of steady income generation. Well-established commercial shopping centers, for example, are often good candidates for cap rate calculations, particularly when they have several long-standing tenants and comparatively low vacancy rates.
Cap rates do not work well for properties with sporadic income. Short-term vacation rentals, for example, often experience seasonal fluctuations, longer vacancy periods, and greater price volatility than long-term residential rentals. The income produced by vacation rentals may not be stable enough to make cap rate calculations useful.
How Are Cap Rates Different from Return on Investment (ROI)?
Cap rates and ROI are similar in that they both measure return potential. However, while cap rates do not take financing into account, ROI does. Cap rates are useful for quickly comparing one asset against another to see which has the better potential. ROI is better for determining the actual return received for every dollar invested over time.
How Capitalization Rates Are Calculated
To calculate a property’s cap rate, divide the property's NOI by its current market value. Then, multiply the result by 100 to convert the figure into a percentage.
The Cap Rate Formula
The cap rate formula is as follows:
Cap Rate = (Annual Net Operating Income (NOI) ∕ Current Market Value) × 100
Steps To Calculating a Cap Rate
The cap rate formula can be broken down into three steps:
Step 1: Calculate the Property’s NOI
The NOI is the property’s total annual income minus the property’s total annual expenses. Income includes rental income, as well as additional income from amenities like parking or paid laundry facilities. Expenses include property taxes, insurance premiums, maintenance, repairs, and vacancy losses. Importantly, any mortgage (principal and interest) is not included in cap rate calculations.
Step 2: Divide the NOI by the Property’s Current Market Value
The current market value can be determined with a formal appraisal or a less formal broker’s opinion of value (BOV). If the property has recently sold, the sales price may be an accurate indicator of the property’s value.
Divide the NOI calculated in Step 1 by the current market value.
Step 3: Convert To a Percentage
The final step is to multiply the result by 100 to convert the result to a percentage.
Cap Rate Calculation Example
Consider a fully occupied multi-family building with a current market value of $2,000,000. The annual income totals $180,000, and the annual expenses (excluding mortgage principal and interest) total $36,000.
Here is how the cap rate would be calculated based on this information:
- The NOI from subtracting $36,000 in expenses from $180,000 in income is $144,000 (180,000 - 36,000 = 144,000).
- The quotient from dividing the $144,000 NOI by the $2,000,000 value is .072 (144,000 / 2,000,000 = .072).
- Multiplying .072 by 100 converts the decimal into a percentage of 7.2%. This is the cap rate.
How To Interpret Cap Rates
Cap rates indicate the number of years it may take to recover the amount invested in a property. For example, it would take around 7.2 years to recoup your investment in a property with a cap rate of 7.2%.
However, this is not a perfect calculation as it does not take debt financing, the time value of money, or future property improvements into consideration.
When comparing two properties, the property with the higher cap rate likely comes with more risk, but also provides greater return potential.
There is no magic number that serves as a “good” cap rate. Rates vary by property type, property condition, local market, and general economic conditions. And, because different investors have different risk tolerance, a “good” cap rate for one investor might feel too risky or too safe for another investor. That said, commercial real estate investors tend to look for cap rates in the 4-10% range.[1]
Factors that Can Affect Cap Rates
Multiple factors can affect cap rates, including:
- Location: Properties in high-demand areas, like major cities or business hubs, typically have lower cap rates because they're considered safer investments.
- Interest rates: Rising interest rates often lead to higher cap rates. This is because higher interest rates make borrowing more expensive, which can reduce the amount investors are willing to pay for properties.
- Property type: Some property types carry more risk than others. This can vary by market, but as a general example, commercial retail spaces are riskier than residential properties.
- Property condition: Older structures with deferred maintenance might have higher cap rates because of higher maintenance costs.
- Rent Control Laws: In markets with strict rent control, cap rates could be elevated due to the limitations on income potential.
The Bottom Line
Capitalization rates are a useful tool for quickly analyzing the profitability potential of a real estate investment. With only the annual income, annual expenses, and current value of a property, you can calculate the cap rate to provide valuable insights into the risk profile and rate of return.
Are you looking for your next investment property? Innovative commercial real estate solutions could help you get the financing needed to fund your next project.
