Knowing the cap rate formula will help you, as a real estate investor, know how to look for the right and profitable rental properties in an area.
A wise real estate investor knows that cap rates are one of the best ways to determine an investment property’s profitability. But what is the cap rate formula and how does it affect real estate investors like you?
Table of Contents
- What Is Capitalization Rate?
- How to Calculate Cap Rate
- What Factors Influence Capitalization Rate?
- What Is a Good Cap Rate?
- What Are the Uses of the Cap Rate Formula?
There’s no doubt about it; rental properties are profitable. It is true especially today, when housing is getting more and more expensive as each day passes. It is why measuring profitability in real estate investing is crucial if you want to get into rental property investments. Always remember that not all rental markets are created equal.
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 the cap rate 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 because it uses the property’s fair market value as one of the factors for calculation. Typically, cap rates are used under the assumption that the purchase will be an all-cash transaction. The divisor used in the cap rate calculator is the actual fair market value of the property being sold.
Its counterpart, the cash on cash return, on the other hand, considers financing methods in its formula to compute the return on your investment on a dollar-for-dollar basis. Cash on cash return calculations are ideal for investment property analysis if you will be taking out a loan to purchase an investment property.
Any real estate investor knows the cap rate’s main purpose is to measure the rate of return on rental property. However, it comes with other uses too, which we will discuss later.
Related: Income Calculator for Real Estate Investors: How to Calculate Your Earnings
How to Calculate Cap Rate
The cap rate is a significant metric to make a fair projection on an investment property’s return on investment. For a lot of people, dealing with numbers and formulas might seem a little overwhelming, even with calculators, but it doesn’t mean that calculating cap rate is difficult.
Here’s how it’s done:
Breaking Down the Cap Rate Formula
The cap rate is defined as the ratio of an investment property’s net operating income (NOI) and its 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.
You can use the cap rate formula in real estate for any rental activity period. For instance, you can calculate the cap rate for a month’s or week’s rent. However, the standard time period of the formula is one year. Measuring things annually makes more sense from a real estate investing standpoint.
Here is the formula for calculating your NOI:
NOI = Annual Gross Rental Income – Annual Operating Expenses
Gross rental income simply refers to the rental income collected for the entire period being considered. Operating expenses include costs that keep a rental property running for the same amount of time.
There are a variety of operating expenses out there. Common examples of expenses included in the cap rate formula are:
- Property management fees
- Maintenance costs
- HOA fees
Financing costs, however, are not considered a type of operating expense here and are excluded from the real estate cap rate formula. As mentioned earlier, financing is not a part of the cap rate formula. However, it is a crucial component of determining a subject property’s potential cash on cash return.
Related: How to Find Rental Properties With a Good Cap Rate in 2022
Fair Market Value
The second variable in the formula for cap rate is a property’s fair market value (FMV). Also known as current market value, FMV is the property’s value in a fair market. In effect, it is similar to the property price.
A property’s fair market value is important when working on an investment property analysis. The subject property’s ROI and income-generating potential will be based on its price, after all.
To find out how to determine a property’s fair market value, you can:
Get an Appraisal
An appraisal is the easiest way to find out how much a property is currently worth in the market you’re considering. Note that each property comes with unique features and characteristics that can boost or take away from its overall value. Regardless, an appraisal directly affects a property’s fair market value.
During an appraisal, a licensed professional inspects and evaluates the home. The appraiser’s evaluation is then factored in with other determining factors like location and real estate comps.
Perform Due Diligence
Generally, professional appraisers use a sales comparison approach where they take a look at actual market conditions and make some sort of comparative market analysis. In simpler terms, they take a look at similar comparable rental properties or rental comps.
You can do it on your own; you just need to put in the work. Researching a prospective rental market may take a lot of time and effort, but if you do it right, they’re worth it in the end.
Fortunately, doing due diligence is a lot easier now with the help of a real estate website like Mashvisor. Mashvisor helps real estate investors to make the right investment decisions by accessing the platform’s data and tools.
The platform maintains a massive database that covers almost every area of the 2022 US housing market. In addition, it also offers valuable tools that will help you find the most profitable investment properties anywhere in the country. Its Property Finder tool, real estate heatmap, and investment property calculator are some of the best out there right now.
To start looking for and analyzing the best investment properties in your city and neighborhood of choice, click here.
Cap Rate Calculation Example
Now that we’ve answered the question, “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%
Save yourself the trouble of doing all this math and try out Mashvisor’s cap rate calculator.
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 the cap rate. Above all, three factors influence a property’s cap rate:
Location is the most important feature in real estate. As a result, there should be no surprise that it affects the cap rate formula.
A good cap rate range changes based on location. Rural and suburban areas, for instance, tend to show higher cap rates than the metro and urban centers.
2. Rental Strategy
Your rental strategy also impacts the cap rate for your rental property. Since short term rentals are rented out on a nightly basis, they tend to be more profitable than long term rentals. As a result, short term rental properties usually demonstrate higher cap rates than their long-term rental counterparts.
However, that’s not to say that long-term rentals aren’t a sound business strategy. It will still largely depend on your location. Several locations are home to better long-term rental markets than vacation rental markets. So, before you come up with a final strategy, you should find out first which strategy will work best for the market you’re in and your investment goals.
Related: How to Use Airbnb Predictive Analytics to Earn a High ROI
3. Investment Property Type
Lastly, property types are another key influencer for the cap rate. The logic flows similarly to our previous point. For example, multi-family properties tend to show higher cap rates than single-family homes. It is because multi-family properties are more profitable. Therefore, what is considered a good cap rate for single-family homes is lower.
Single-family units may be more affordable compared to multi-family properties. The state-level median property price for a single-family home in the US today, based on Mashvisor’s latest November 2022 data, is $475,720 (Tennessee).
Let’s consider Dallas, TX, for instance. A single-family unit in Dallas shows a median price of $603,079 with a cap rate of 2.81%. The cap rate is decent enough since it is above 2.00%. However, it will take longer to recoup your investment since Dallas is considered a strong renter’s market, and the competition is intense for single-family rentals.
On the other hand, a 10-unit multi-family facility in Dallas will cost you anywhere between $3 to $7 million and get you a cap rate as high as 6.81%.
As an investor, you must know your priorities and financial capacity if you are going to choose between a multi-family property or several single-family homes.
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 of 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.
Check out Mashvisor’s real estate heatmap to help you find profitable investment properties.
What Are the Uses of the Cap Rate Formula?
We’ll wrap up this blog with how you can use 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. It is especially true for an 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 give 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. You can easily lose objectivity, given the various factors associated with real estate investing. 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, the cap rate also estimates the payback period of a property. The payback period is the time it takes until the real estate investor earns back the total investment 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
When it comes to payback periods, the shorter it is, the better the investment. In the same breath, the longer the payback period, the less desirable a property is.
Not all investments are on the same time horizon. You need to use your better judgment to determine whether a subject property is worth investing in or not based on how long the ROI will take.
Related: The Ultimate Guide to Real Estate Investing for Beginners
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.
Knowing how to compute a property’s cap rate gives you a better idea of its earning potential, as well as its payback period. It is why you need to familiarize yourself with the market you’re considering. If you’re unaware of the actual market conditions, you may end up regretting your decision later on.
To avoid buyer’s remorse, we highly recommend signing up for Mashvisor. As a real estate platform, it will arm you with the most accurate information and up-to-date data that will give you highly realistic ROI projections.
Tools like the investment property calculator and real estate heatmap will lead you to the most profitable properties in any location of your choice.
To know more about how Mashvisor and its tools work, schedule a demo with us today.