There’s no doubt about it, rental properties are profitable. This statement is a no-brainer. However, measuring profitability in real estate is not. Beginner investors might believe that rental income is the be-all-end-all metric of profit. While rental income is essential, it isn’t the best way to determine financial gain. Calculating return on investment (ROI), on the other hand, is the best method to estimate profit. One vital return on investment metric is the cap rate. In this blog, we’ll focus on this metric. Specifically, we’ll discuss what’s included in the cap rate formula.
What Is Capitalization Rate?
So, what is cap rate? Short for capitalization rate, it is one of the key real estate ROI metrics. It computes how much of the property value is generated as a profit. As a result, the cap rate formula depends on income, expenses, and property value. The cap rate measures ROI regardless of how investment property is financed. Cap rate’s main purpose is as a measure of the rate of return on rental property. However, it has other uses too, which we’ll discuss later.
How to Calculate Cap Rate
Cap rate is a significant return on investment metric. But that doesn’t mean that calculating cap rate is difficult. Here’s how that’s done.
Breaking Down the Cap Rate Formula
Cap rate is defined as the ratio of an investment property’s net operating income and it’s property value. Therefore, the cap rate formula is:
So, what exactly are net operating income and fair market value?
Net Operating Income:
Net operating income (NOI) is the first variable in the cap rate calculation. NOI is the difference between gross rental income and operating expenses. The cap rate formula in real estate can be used for any rental activity period. You can, for instance, calculate cap rate for a month’s or week’s rent. However, the standard time period of the formula is one year.
NOI = Annual Gross Rental Income – Annual Operating Expenses
Gross rental income simply refers to the rental income collected. Operating expenses are costs that keep a rental property running. There are a variety of operating expenses out there. Common examples of expenses included in the cap rate formula are:
- Taxes
- Property management fees
- Maintenance costs
- Insurance
- Vacancies
- HOA fees
Financing costs, however, are not considered a type of operating expense here and are excluded from the real estate cap rate formula.
Related: A Guide to the Net Operating Income Formula for Rental Properties
Fair Market Value:
The second variable in the formula for cap rate is fair market value (FMV). Also known as current market value, FMV is property value in a fair market. In effect, it is similar to the property price.
Cap Rate Calculation Example
Now that you know what is the cap rate formula, let’s test your knowledge with an example. A $275,000 investment property generates $30,000 in annual gross rental income. At the same time, it costs $6,000 to operate. What is its cap rate?
Cap Rate = ($30,000 – $6,000) ÷ $275,000 = 0.87 = 8.7%
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What Factors Influence Capitalization Rate?
Is the cap rate in the above example considered good? Before we answer that, we need to discuss the factors that impact cap rate. Above all, three factors influence cap rate:
1. Location
You’ve probably heard this a thousand times, but location is the most important feature in real estate. As a result, there should be no surprise that it affects the cap rate formula. The good cap rate range changes based on location. Rural and suburban areas, for instance, tend to have higher cap rates than metro areas.
2. Rental Strategy
Rental strategy also impacts the cap rate for rental property. Since short-term rentals are rented out on a nightly basis, they tend to be more profitable than traditional rentals. As a result, Airbnb properties usually have higher cap rates than their traditional counterparts.
Related: Airbnb vs. Long-Term Rental: Which One Is Better For You?
3. Investment Property Type
Lastly, property types are another key influencer for cap rate. The logic flows similar to the previous point. For example, multi-family properties tend to have higher cap rates than single-family homes. This is because multi-family properties are more profitable. Therefore, what is considered a good cap rate for single-family homes is lower.
What Is a Good Cap Rate?
So, what is a good cap rate? The answer is not as cut-and-dry as many might think. Nonetheless, there is a general ‘good’ cap rate range: 8% to 12%. Regardless, it’s important to remember that real estate is a local business. All that truly matters is what is a good cap rate in your location. What’s better is that you can easily find that out with Mashvisor! Mashvisor’s heatmap analysis is the ultimate tool for studying any rental market. To learn more about the heatmap, CLICK HERE!
What Are the Uses of the Cap Rate Formula?
We’ll wrap up this blog with the uses of the cap rate formula. There are three uses that are most important to real estate investors:
1. Determine Return on Investment
Determining the return on investment is the most highlighted use of the cap rate. This is especially true for investment property purchased fully with cash. In such a scenario, the cap rate for investment property is the direct measure of its ROI. Cap rate is also useful for mortgage-financed properties. However, cash on cash return will project a more accurate ROI forecast. Nonetheless, the higher the cap rate, the more profitable the rental property.
2. Compare Investment Properties for Sale
Comparing investment properties can be tricky. With the various factors associated with real estate investing, objectivity can easily be lost. But, the cap rate makes it easier. Because it excludes financing from its formula, it is an unbiased measure of profitability.
3. Estimate the Payback Period
Finally, cap rate also estimates the payback period of a property. The payback period is the amount of time it takes until the real estate investor earns back the total investment put into the property. To estimate the payback period, simply divide 100 by the cap rate.
Payback Period = 100 ÷ Cap Rate
For the previous example, the payback period is:
Payback Period = 100 ÷ 8.7 = 11.5 years
Related: Real Estate Investment Payback Period: A Beginner’s Guide
The Bottom Line
All in all, the cap rate is a powerful metric in real estate investing. The cap rate formula is very simple, but it also carries much weight and analysis with it.
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