What Is Cap Rate in Real Estate Investing?
Cap rate (capitalization rate) is a metric used in real estate investing for analyzing an investment opportunity and determining its estimated return on investment.
The cap rate metric is one of the most commonly used methods for calculating the return on investment in real estate investing, and it is an especially useful metric for analyzing rental properties.
So, what is cap rate? Simply, the cap rate metric is used to express the rate of return that a rental property’s rental income has in relation to the current market value of the investment property. In other words, the cap rate is a percentage-based metric that indicates the amount of profit that your investment property will generate each year as a percentage of the current market value of the property.
What Is Cap Rate in Analyzing a Real Estate Investment?
Now that you know what is cap rate, let’s see how it’s used in analyzing a real estate investment.
When analyzing a real estate investment, real estate investors use the cap rate to determine the expected profitability of the investment property. In order to do that, real estate investors need to do some research and gather enough data to base their calculations on.
The main data and information that real estate investors need to learn about the investment property before calculating its cap rate includes:
- The annual rental income or the amount of rent that they can set for the property.
- The annual recurring expenses that will apply to the rental property.
- The annual cash flow of the property (annual rental income – annual expenses).
- The current market value of the property.
Additionally, to make the most out of the cap rate metric, real estate investors can use the cap rate when conducting a real estate market analysis, allowing them to determine the most profitable investment property out of a number of similar properties based on their cap rate value.
However, this does not always mean that the higher the capitalization rate of an investment property, the better it is. In some cases, a higher capitalization rate might indicate a higher risk rate. For this reason, real estate investors need to find the balance when doing a real estate market analysis to determine the best capitalization rate for the investment property that they want to purchase, and they will have to decide on the profitability level that they would like to have as well as the risk rate associated with it.
How to Calculate the Cap Rate for an Investment Property?
Now that you know what is cap rate in analyzing an investment, let’s see how it is calculated. To calculate the cap rate, a real estate investor will need to have gathered the data and information mentioned above.
The formula for calculating the capitalization rate is very straightforward and simple:
Capitalization Rate = Annual Cash Flow/Current Market Value x 100
So, to put it all into perspective, let’s take a look at a couple of examples to give you a better understanding of how the capitalization rate is calculated when analyzing a rental property.
Example #1:
A real estate investor wants to purchase a rental property that has a market value of $200,000 using 100% cash. This rental property has the potential for a rental rate of $1,000/month, or $12,000/year. The expenses that will apply to this property amount to $400/month, or $4,800/year. This means that the annual cash flow of this rental property is $7,200 ($12,000 – $4,800).
What is cap rate for this rental property? Let’s have a look:
Capitalization Rate = $7,200/$200,000 x 100
Capitalization Rate = 3.6%
This means that this rental property will generate a rental income that is equal to 3.6% of the current market value of the property each year.
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Example #2:
A real estate investor wants to purchase a rental property that has a market value of $200,000, but he/she will be financing the purchase using a 60% mortgage. Similar to the first example, this rental property is expected to generate an annual rental income of $12,000/year. Unlike the first example, because a mortgage was used to purchase the property, the annual expenses will now include the mortgage payback, which is a considerable amount of money. The annual expenses for this property are now $9,000/year. The annual cash flow of this property is $3,000 ($12,000 – $9,000).
What is cap rate for this rental property? Let’s have a look:
Capitalization Rate = $3,000/$200,000 x 100
Capitalization Rate = 1.5%
As you can see, even though the cap rate does not account for the method of financing in its calculation, but instead relies on the current market value of the property and assumes the purchase is always made using 100% cash, the method of financing can drastically affect your capitalization rate due to the mortgage payments adding up to a significant amount of your annual expenses.
In this case, a different metric can be used to balance out your analysis and give you a better idea of the expected return on investment. This metric is the cash on cash return.
What Is Cap Rate in Comparison to Cash on Cash Return?
The main difference between the capitalization rate and the cash on cash return metrics is that while the capitalization rate does not account for the method of financing used for purchasing the property, the cash on cash return metric only takes into consideration the amount of actual cash that the real estate investor has paid from his/her own money.
In other words, the cash on cash return is a metric used for analyzing an investment property to estimate its return on investment based on the percentage of rental income that the property will generate in relation to the amount of actual cash invested in the property.
The formula for calculating the cash on cash return, then, is this:
Cash on Cash Return = Annual Cash Flow/Cash Invested x 100
To give you a quick example of how this is calculated, let’s revisit the previous examples:
Example #1
For this example, the investment property was purchased using 100%. This means that there is no mortgage to be taken into consideration, and so the value of the cash on cash return will be identical to the capitalization rate of the property, which is 3.6% as we saw in that example.
Click here to find investment properties with readily calculated metrics based on your financing method.
Example #2
This is where the difference between the two metrics can be seen. In this example, the investment property was purchased using 60% borrowed money and 40% cash. This means that the real estate investor who purchased the $200,000 investment property only paid $80,000 of his/her own money.
Using the same values for the rental income and the expenses, the calculation of this property’s cash on cash return would look like this:
Cash on Cash Return = Annual Cash Flow/Cash Invested x 100
Cash on Cash Return = $3,000/$80,000 x 100
Cash on Cash Return = 3.75%
Bottom Line
Back to the first question — What is cap rate in real estate investing?
The capitalization rate is one of the most valuable metrics used in real estate investing when analyzing an investment property’s projected profitability. When combined with other metrics, such as the cash on cash return, real estate investors are able to conduct a real estate market analysis or an investment property analysis and achieve accurate results to help them determine the optimal investment property to invest in, and to know exactly how much money that investment property is expected to make in relation to its value or the cash they invested in it.
Related: What Is Cap Rate and How Does Mashvisor Utilize it for Investment Property Analysis?
If you’re not fond of math and numbers, and would rather have this information and these metrics calculated for you without having to gather the data and calculate them on your own, we’ve got you covered! With Mashvisor, you will gain access to the capitalization rate and the cash on cash return for any investment property listed on the market for sale. Not only that, but the platform will also give you the average cap rate and cash on cash return for each market or neighborhood, allowing you to easily do a comparative real estate market analysis and identify the investment properties with the highest potential for profits in that market.