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
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.
What is the ideal cap rate for an investment property? ›
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.
Is 7.5% a good cap rate? ›
Generally, a cap rate of 8-10% is considered a good cap rate for a rental property, however, cap rates can vary significantly depending on the market and the type of property. For example, a cap rate of 6-7% may be considered good for a multifamily property in a high-demand market.
What is the 2% rule for cap rates? ›
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 cap rate is too high? ›
Generally, a high capitalization rate will indicate a higher level of risk, while a lower capitalization rate indicates lower returns but lower risk. 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.
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 cap rate is the 1% rule? ›
The 1% rule is a strategy used in real estate investing to determine your cap rate. It states that when evaluating properties, investors should calculate monthly rent to be at least 1% of the total purchase price.
What if going out cap rate is lower than going in? ›
If the exit cap rate is lower than the entry cap rate, the combination of increasing NOI and a lower cap rate will result in a substantial increase in property value. We always advise investors to be wary of this practice.
What is the 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.
Do you want cap rate to go up or down? ›
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.
The cap rate is calculated by taking the net operating income of the property in question and dividing it by the market value of the property. The resulting cap rate value is then applied to the property an investor wants to purchase in order to obtain the current market value based on its annual income.
Should cap rate be higher than mortgage rate? ›
If the cap rate is greater than the interest rate, you'll generally come out ahead. If the cap rate is lower than the interest rate, you'll be relying on appreciation for your return, making it a riskier speculative investment.
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 an 8% cap rate in real estate? ›
Use-case of cap rates
For example, if a real estate investment provides $160,000 a year in NOI and similar properties have sold based on 8% cap rates, the subject property can be roughly valued at $2,000,000 because $160,000 divided by 8% (0.08) equals $2,000,000.
What is the 6% cap rate? ›
If you invested $1,000,000 in a property, with a 6% CAP rate, you would receive $60,000, at year-end. Or if your commercial real estate property is generating $100,000 of net operating income per year and the market's CAP rate is 10%. The value of the property is $1,000,000 (100,000 (property value)/. 10 (CAP rate).
