Real estate investors are driven by the same motivation – to make money from investment properties. How much money you make in real estate investing depends on your return on investment. How do real estate investors measure their return on investment? There are a number of metrics used in real estate investing to do so; one of the most popular ones is the capitalization rate or cap rate for short.
If you’re a beginner property investor, you should know that cap rate is an important term which you’ll be hearing quite a lot throughout your real estate investing career. In this article, we’ll cover what is cap rate, why is it important in the real estate investing business, how does it differ from the cash on cash return metric, the factors that affect it, and how to calculate it. So, keep reading to find out everything real estate investors should know about the capitalization rate!
What is Cap Rate in Real Estate Investing?
In the simplest terms and as mentioned earlier, the cap rate is one of the most widely used real estate metrics to measure the return on investment or the profitability of an income property. What makes capitalization rate a popular metric among real estate investors is that it measures the rate of return regardless of the investment property financing method – all cash or a mortgage loan. In other words, the cap rate is totally dependent on the income property, not on the property investor.
Cap rate corresponds to the level of risk associated with the real estate investment property. This means that low cap rates will correspond to a lower level of associated risks and high cap rates will correspond to a higher level of associated risks. Generally speaking, in real estate investing, the higher the cap rate, the better it is for the property investor. Why so? Well, when it comes to any type of investing including real estate, lower risks yield low profitability, while higher risks yield high profitability!
How is Cap Rate Different from Cash on Cash Return?
Going back to what we already stated about cap rate, it measures the return on investment of a real estate property without taking into account the financing method used to buy the investment property. This is what differentiates cap rate from other metrics used in real estate investing such as cash on cash return.
The cash on cash return is a metric used to analyze and measure the profitability of an income property taking into consideration the investment property financing method – all cash or mortgage loan. In other words, unlike capitalization rate, the cash on cash return metric estimates the return on investment on a real estate property only based on the rental income that the investment property will generate in relation to the amount of actual cash that the real estate investor invested.
Related: Cap Rate vs. Cash on Cash Return
What Determines Cap Rate in Real Estate Investing?
It goes without saying that cap rates differ from one investment property to another and from one real estate market to another. So, there have to be variables upon which the cap rate depends! Here are the factors that determine the cap rate of investment properties:
Cap Rates Depend on Location
Smart real estate investors already know that location is a major key that affects every aspect of real estate investments including the cap rate. A busy urban location, such as New York, will have a very different cap rate from a rural location like a small village in Texas. Why so? The value and therefore the profitability and return on investment of a real estate property are determined by the demand and associated risks in the local real estate market.
Think of it this way: due to the high demand, the prices of investment property will rise up. Furthermore, in a real estate market with high demand for investment properties, there will be lower associated risks. Remember, lower associated risks yield lower profitability. Therefore, a real estate investor is likely to generate a higher cap rate in a real estate market with low demand and high associated risks.
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Cap Rates Depend on the Investment Property Type
The second factor that determines cap rates is the type of investment property. The type of investment property – single family home, multi-family property, townhouse, condo, or apartment – also affects the associated risks and thus the capitalization rate. For example, real estate investors rarely face 100% vacancy rate with multi-family homes, which means these investment properties have lower associated risks, and thus lower cap rates. On the other hand, a real estate investor with a single family home will have higher risks of facing 100% vacancy rate if he/she can’t find a tenant. With this high level of associated risks, these investment properties yield higher cap rates and return on investment.
However, the real estate investing market is ever-changing and we can’t generally say that one type of income property will most definitely yield a higher return on investment! Real estate investors have to remember that the location also determines which type of investment property is more profitable. The rental strategy (traditional or Airbnb) also affects profitability.
For example, in many real estate markets, a single family home is considered the more stable real estate investment meaning it has lower associated risks. In these specific real estate markets, the capitalization rate may be lower for single family homes when compared to multi-family homes.
Related: Best Long-Term Investments: Single-Family and Multi-Family Homes
Cap Rates Depend on the Interest Rate
The relationship between cap rates and interest rates is not a simple one. This is why many real estate investors don’t realize that interest rates in a real estate market can, in fact, affect the cap rate. When interest rates go up – even if nothing else changes about the real estate market or the investment property – so do cap rates.
This is because as interest rates increase and debt service becomes more expensive, a property investor will have to pay less for an investment property in order to achieve a decent return on investment. Due to the state of the real estate market, sellers will have to lower their prices and, as a result, cap rates will go up. It’s important that a property investor keeps interest rates in mind to determine the cap rate and value of investment properties.
Related: 7 Factors Affecting the Value of Your Income Property
How to Calculate Cap Rate in Real Estate Investing
There is a pretty simple mathematical formula which any property investor can use to calculate the capitalization rate of an income property, which is:
Cap Rate = NOI/Property Price
To calculate the annual net operating income (NOI) of an investment property, the property investor multiplies the monthly rental income by 12 and subtracts any rental expenses from it, including property tax, insurance, management fees, utility costs, maintenance, etc. As previously mentioned, the formula to calculate cap rates assumes all method of investment property financing, thus you don’t need to worry about the finance costs. The property price is simply the purchase price of your income property plus any other costs related to the purchase such as real estate agent’s fees, brokerage fees, closing costs, rehab costs (if any), etc.
Let’s look at an example to further explain: say a property investor purchased a $200,000 investment property and paid another $10,000 to finalize the purchase. Assume the property investor is renting out his income property and charges $1,700 as monthly rent. Further, assume that annual operating costs add up to $5,000. What’s the cap rate for this income property? Let’s calculate:
NOI = Monthly Rental Income x 12 – Annual Operating Costs = $1,700 x 12 – $5,000 = $15,400
Property Price = Property Value + Other Costs = $200,000 + $10,000 = $210,000
Cap Rate = NOI/Property Price = $15,400/$210,000 = 7.3%
In our example, is 7.3% a good cap rate for real estate investments? Most real estate experts agree that anything in the range of 8 – 12% is a good cap rate. However, realistically speaking, seeing as the real estate investing market has changed in recent years, anything above 5% is actually a good cap rate!
Final Words on Cap Rate in Real Estate Investing
To sum up, cap rate in real estate investing is a metric used to measure a property investor’s return on investment. It does so without taking into account the investment property financing method – which what makes it different from the cash on cash return metric. The location, type of the investment property, and interest rates are variables upon which the cap rate depends. To calculate the cap rate of investment properties, property investors use the above-mentioned formula.
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