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Capitalization rate, or cap rate, is a metric used to determine the rate of return on real estate. It's most often used for commercial property investments, such as office buildings, hotels, or warehouses. However, it can be used with properties that are residential in nature, as well.
To calculate the cap rate for an investment property, take the property’s net operating income and divide it by the property’s market value. For a property you might buy, use the expected purchase price in place of the market value.
A property’s net operating income is the income it generates minus the expenses of managing and operating it. It does not include any debt payments. If you have a mortgage on a property, you’d calculate its net operating income without subtracting the costs of the mortgage payments. Net operating income also doesn't include any capital expenditures or depreciation deductions.
Here’s a rundown of how to calculate a property’s cap rate, why understanding this concept could be useful for real estate investors, and another return metric that could be more useful when determining your investment returns.
An example of calculating cap rate for an investment property
To quickly recap, here are the steps to calculate cap rate for an investment property.
- Determine the property’s gross income. This typically means the rent generated by the property. But includes other income sources, as well (such as laundry facilities in an apartment building).
- Subtract the expenses of managing and owning the property except debt payments, capital expenditures, and depreciation. This gives you the property’s net operating income.
- Divide the net operating income by the property’s market value or your expected purchase price for the property.
- Multiply the result by 100 to convert it to a percentage.
Let’s say that you’re evaluating an office building as a potential rental property investment. You can purchase the building for $1 million and you estimate that it will generate $110,000 in annual rental income. Between property management, taxes, insurance, and other expenses, you subtract $40,000 from the rental income to get the property’s expected net operating income of $70,000.
Dividing $70,000 by $1 million gives us 0.07 and multiplying by 100 gives a cap rate of 7.0%. However, after going through a cap rate calculation like this, the natural question is, "Well, is that good or bad?"
What kind of cap rate should you look for?
There’s no set cutoff for a "good" or "bad" cap rate. It depends on several factors, including the quality of the property and its geographical location. The type of commercial property also plays a big role.
Here are the average cap rates for several types of commercial real estate, according to CBRE’s North America cap rate survey for the first half of 2019.
|Property Type||Average Cap Rate|
As you can see, the type of property you’re talking about makes a big difference. In fact, when you consider the "class" or quality of a property, there are more than five percentage points of difference between the lowest and highest in CBRE’s survey. The highest cap rate (9.74%) is for suburban economy hotels, and the lowest (4.69%) is for Class A (top-quality) urban apartment buildings.
Why cap rate is important for real estate investors
There are two main reasons why cap rates are important.
The first reason is to analyze the performance, or expected performance, of your rental properties. For example, if there are three office buildings in your price range for sale, calculating the expected cap rates for all three can help you determine which is the best investment. Or, if you know the market average cap rates, calculating the cap rate of properties you own can help you determine if they're overperforming or underperforming the industry averages.
The second reason to use cap rates is when you’re considering the sale of an investment property. A little algebra tells us that we can rearrange the cap rate equation to this:
Market value = net operating income / cap rate
Here’s why this is important if you’re selling a property: If you know how your property’s net operating income and the industry average cap rate, you can determine your property’s fair market value.
For example, if you know that the average office building has a 7% cap rate and you own an office building with net operating income of $100,000, understanding the cap rate equation tells you that your property has a fair market value of about $1.43 million.
Cash-on-cash return could be a better return metric for you
As we’ve seen, cap rate can help you compare properties, assess your property’s return, or help you figure out how much you should expect to get when selling a property. However, cap rate isn’t the most useful metric for calculating investment property returns.
Specifically, there are some real-world costs that cap rate doesn’t consider: loan repayment.
For this reason, cash-on-cash return can be a more useful concept when calculating investment returns. This is a measurement of an investment’s net income—including debt repayment—divided by the actual cash you invested in the property.
For example, let’s say that you acquire a $1 million office property and that you put down a 25% down payment ($250,000). Including closing costs and other acquisition expenses, your total cash outlay is $300,000.
The property generates $110,000 in annual rental income and produces net operating income of $70,000 after expenses. On top of this, you pay an additional $40,000 in mortgage principal and interest each year, so your property’s total cash flow is $30,000 for the year. Dividing this by the $300,000 you spent to acquire the property produces a cash-on-cash return of 10%.
If you acquire a property in cash, your expected cash-on-cash return and cap rate should be identical in most cases.
The bottom line
Cap rate can be useful to real estate investors in numerous situations, including
- evaluating potential investment properties,
- assessing the performance of properties you own relative to others, and
- determining a fair market value for your properties.
However, there’s no easy answer to the question "What is a good cap rate?" There are too many variables that determine cap rates for property types and too much variation to give a one-size-fits-all answer.
While there’s no specific "good" or "bad" cap rates, understanding the concept can help you make smarter real estate investment decisions and evaluate the performance of your properties.
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