Are you looking for a property that will give you profits as a real estate investment? Then, you need to learn about the cap rate calculation.
So, you’ve learned the many benefits of investing in real estate and decided to buy your first rental property. Not so fast. Just because there’s money to be made in real estate, not every piece of real estate is profitable.
Table of Contents
- What Is Cap Rate in Real Estate?
- What Is the Cap Rate Calculation?
- Example of How to Calculate Cap Rate
- 4 Factors Affecting Cap Rates in Real Estate
- How to Find High Cap Rate Properties for Sale
Some investment properties will even cost you more than they’ll make you. You don’t want to end up in that situation, correct? This is why the most crucial aspect of real estate investing that beginner investors must learn before jumping into the industry is how to analyze investment opportunities.
Basically, it is the process of running the numbers behind a potential real estate investment early on to tell you if this deal is promising or not.
There are a number of metrics or calculations that property investors use for analyzing rental properties, the most common of which is the cap rate calculation. In this Mashvisor’s guide for beginner investors, we’ll explain what the cap rate is, why it’s essential, and how to calculate it. Let’s get started.
Related: What Are the Most Important Metrics in Real Estate Investment Property Analysis?
First Thing’s First: What’s Cap Rate in Real Estate?
The cap rate (capitalization rate) is commonly used in real estate to refer to the rate of return on a rental property. It is based on the property’s net operating income (NOI) concerning its current market value.
A real estate investor can use the cap rate calculation to analyze a certain deal or compare different investment opportunities. For example, if all else is equal, an investor is most likely to buy a property with a 10% cap rate versus another with a 3% cap rate.
In addition, the cap rate is also understood as a measure of risk in real estate investing. So, a higher cap rate tells property investors that the investment is riskier, and a lower cap rate means an investment is less risky.
Keep in mind that it is the same principle that gives you a lower return on investment for low-risk assets than for riskier assets. It means that while high cap rate properties can be riskier, they also give a higher return on investment. Of course, the theory varies depending on the type of property you’re looking at and its location, as well as its condition.
But as a real estate investor, you shouldn’t just pay attention to the potential returns or profit from the rental property. You must also estimate and protect yourself against the possibility of losing money (risk). It is another reason why the cap rate calculation is great for analyzing real estate opportunities.
Cap rate calculation enables you to make investment decisions more confidently when you balance risks and rewards.
So, What’s the Cap Rate Calculation?
Visual representation example of the cap rate formula:
As mentioned, the cap rate is the ratio of a rental property’s net operating income to its market value. If you’re not familiar with the NOI, it’s simply your annual rental income generated by the property minus all operating expenses, including management, taxes, vacancy, insurance, repairs, HOA costs, etc.
The calculation of the cap rate metric is done based on the net income that the property is predicted to earn and is represented as a percentage. The formula goes like the following:
Capitalization Rate = Net Operating Income / Current Market Value
- Net operating income is the yearly (expected) income produced by the property. In addition, it gained by deducting all the costs incurred for property management. These expenditures include the cost of routine facility maintenance as well as real estate taxes.
- Current market value is the latest (as of now) property value as per the dominant market rates.
Moreover, the formula is used in the calculation of the possible return on an investor’s real estate investment.
It’s important to note that the cap rate calculation/formula does not take the financing costs into account. It is because NOI does not include mortgage payments or interest payments. Excluding debt is part of why the cap rate is so useful to real estate investors.
The assumption that the investment property is bought in cash lets you focus on the property itself and its profitability instead of being distracted by debt and financing. It also lets you better compare the risk of one property (or market) to another.
Example of How to Calculate Cap Rate
You’re a real estate investor looking to buy a rental property. You’ve saved up enough cash as you plan to buy the investment property without taking out a mortgage. From this blog, you will remember that the cap rate calculation is an effective and quick metric for evaluating the profitability of rental properties.
After searching in your local market, you’ve found three properties for sale with their respective expenses, annual rental income, and market values:
After doing the calculations for the rental properties above, you realize that Property C returns the highest cap rate.
There are various circumstances in which the return, as measured by the capitalization rate, might vary greatly.
Here is the first example. A couple of the renters may move out, and the rental revenue from the home may fall to $50,000. After deducting $20,000 for various upkeep and real estate taxes and assuming that the property’s value stands at $1.2 million—the cap rate is ($30,000 / $1.2 million) = 3%.
In another example, if the property’s present-day market value falls to $700,000 but the rental income and other expenditures stay constant, the cap rate rises to $60,000/$700,000 = 8.6%.
In summary, several factors can significantly influence the capitalization rate. They include variable levels of revenue that are generated from the asset, costs associated with the property, and the existing market value of the property.
Related: Where to Find the Best Beginner-Friendly Cap Rate Formula Calculator
4 Factors Affecting Cap Rates in Real Estate
To decide if you’re getting a good cap rate and judge the risk of the real estate investment, you need to understand the three major factors that affect the cap rates of rental properties:
1. Economics and Demographics
The cap rate is different in different cities and locations. Let’s say you want to buy an investment property in a major city like San Francisco. It’s a big city with a strong economy and high rental demand. At the same time, new supply is lacking in the city because of land shortages and regulatory restrictions.
Such economic and demographic factors affect real estate values (i.e., higher property prices). For this reason, rental properties in San Francisco show low cap rates, so investing here is less risky. It means that real estate investors should be willing to accept lower returns because of the lower perceived risk.
On the other hand, the economic and demographic fundamentals of a small-town housing market are different. The said locations are economically not as strong as major cities that have diversified economies.
Therefore, real estate investors will need to find properties with higher cap rates to compensate for the higher risk. It also tells you that you should not use the cap rate calculation to compare rental properties in different locations.
Related: What Cap Rate by City Can You Expect as a Real Estate Investor?
2. Local Real Estate Market
Cap rates are not just different between cities but also between neighborhoods within a city. Remember, real estate is very local. For example, consider analyzing two properties in different neighborhoods—one is highly desired and attracts demand for rentals, while the other is a run-down part of the city.
You’ll notice that investment properties in the run-down part of the city have a higher cap rate, reflected by lower market values. On the other hand, a property located in the desired neighborhood would have a lower cap rate—reflected by higher market values.
That doesn’t make it a bad place to invest in real estate! It’s only a matter of understanding risks and figuring out how to address them.
3. Type of Investment Property
Finally, to determine if you’re getting a good cap rate, you also need to account for the type of real estate property you’re investing in. For example, the cap rate calculation will provide lower results for a residential real estate asset than a commercial one in the same location.
Likewise, multifamily homes are known to have lower cap rates than single family homes. What’s the difference? Again, it all goes back to risk.
During a recession, a retail shop might go out of business, but people will still need to live somewhere. It means the residential rental property will likely remain occupied and generate income even if rental rates are lower. The owner of the retail shop, however, could face long vacancies. Thus, residential properties provide lower cap rates because they have lower risks.
Moreover, even residential property types have different cap rates. For example, multifamily homes and apartment buildings will generate rental income from numerous tenants even if one tenant doesn’t pay the rent for the month.
However, if you’re investing in a luxurious single-family home and your tenant didn’t pay the rent, you’ll be left with no rental income that month to cover your expenses. Higher risk = higher cap rate. It is why investors should use the cap rate calculation to compare real estate properties of the same type.
4. Rising Interest Rates and Excessive Supply
Cap rates seem to go up when interest rates rise, as a general principle. Such a trend reflects the higher cost of borrowing, which implies that returns also need to grow to keep the same profitability level. Property prices must decline in order to generate higher returns.
If the market is oversupplied, it is natural for rental rates to decline in response. Decreasing rental rates raise the risk of a property. Hence, returns must grow to compensate investors for the higher risk.
How to Find High Cap Rate Properties for Sale
Want an easy way to find profitable investment properties for sale in the US housing market without doing the cap rate calculation? Mashvisor’s Property Finder allows you to do just that. With the tool, you simply customize your search criteria by setting filters, including your:
- Preferred Rental Strategy
- Type of Investment Property
- Number of Bedrooms and Bathrooms
From there, the Property Finder tool will give you a list of the highest cap rate properties for sale in your selected city. And after you’ve selected a few potential properties, you can use the investment property calculator. It will help you do a full property analysis to make sure you’ll get a good return on investment.
Mashvisor’s Cap Rate Calculator
This is the section where our quick cap rate calculator tool excels. There is no need for you to waste any more time on the manual work and numerous spreadsheets.
When you select any listed property on Mashvisor, you will be directed to the rental analysis page for that home. The page contains all of the details you need to know about the house, including information on the current landowner and contact info if it was presented.
However, you will also have access to the cap rate formula calculator, which is completely adjustable but comes already filled out with market average values.
The calculator includes three major features:
- The primary calculator at the top displays the outcomes for both long term and short term rentals using the cash return and cap rate metrics. It also calculates the property’s occupancy rate.
- The bottom expenditures area is filled with market-average relevant expenditures such as rental and property income taxes, property management, HOA fees, closing costs, and more. You can also alter the parameters as you see fit or add new ones if desired.
- On the right, there is a mortgage calculator that contains the mortgage type, length (duration), interest rate, and amount.
This page will also feature other facts regarding your investment’s long term expectations, like the 10-year pay-back rate or comparisons of other similar properties. They will all be extremely beneficial at this time.
To get access to our real estate investment tools, sign up for a 7-day free trial of Mashvisor today.
Cap Rate Calculation: Conclusion
While the cap rate calculation is important in analyzing and comparing real estate investment opportunities, it’s only one of many metrics to find the rate of return. So, property investors should use the cap rate calculation together with others (like the gross rent multiplier and cash on cash return) to ensure making the right investment decisions.
Moreover, the Mashvisor cap rate calculator is the most practical in its category. Get access to the various unique tools and features that work in harmony with our cap rate calculation tool.
Do you want to learn more about Mashvisor’s tools? Schedule a free demo with one of Mashvisor’s Product Specialists.