In order to understand how well rental investment properties are performing, you need to know the return on investment (ROI) of the properties. There are various ROI metrics out there, like cash on cash return and cash flow. One of the most important ROI metrics, which is the topic of this blog, is the capitalization rate.
What’s a Cap Rate?
The capitalization rate, or cap rate for short, is the real estate ROI of an investment property based on the income, the expenses, and the value of the property. In other words, it is how much of the rental property’s value the real estate investor is receiving as a profit. Cap rate tends to be expressed as a percentage. The percentage is taken from a ratio of the investment property’s net operating income and its value. This powerful real estate metric tells a lot about the profitability of investment properties. It is also relatively simple to calculate.
How to Calculate Cap Rate?
Cap rate is the ratio of an investment property’s net operating income (NOI) and its current market value expressed as a percentage.
Capitalization Rate = (Net Operating Income/Current Market Value) × 100%
So, what exactly are NOI and current market value?
Net Operating Income:
NOI is the difference between the annual rental income of an investment property and its operating expenses.
Net Operating Income = Annual Rental Income – Operating Expenses
Operating expenses are essentially expenses that keep rental investment properties running. Examples include taxes, insurance, and maintenance costs. Mortgage payments are not considered operating expenses; instead, they are financing costs. How does mortgage fit in with the capitalization rate equation? More on that later.
Current Market Value:
The fair market value (FMV) of an investment property can have a tremendous impact on its cap rate. This is especially true since the FMV tends to change over time. For that reason, using the current market value of a rental property produces the most accurate and meaningful results.
Related: What Are the Main Property Valuation Methods?
Here’s a quick example on how to calculate cap rate. If a $300,000 property has an annual rental income of $32,000, and its operating expenses are $2,000, what is its cap rate?
Cap Rate = (($32,000 – $2,000)/$300,000) x 100% = 10%
What Is a Good Cap Rate?
The answer of our example begs an important question: is it a good cap rate? According to most experts, yes! A good cap rate is from 8% to 12%, and obviously anything higher is even better.
What Are the Limitations of Capitalization Rate?
As previously mentioned, mortgage is not included in the capitalization rate. This leads us to the limitations of an investment property cap rate.
Does Not Consider Method of Financing
A capitalization rate tells you many things (which will be discussed later). Unfortunately, it is limited in that it does not truly generate the return on investment for a property unless it is paid fully in cash. Investment properties financed through a mortgage can use a modified version of the cap rate to determine the real estate ROI. This metric, called the cash on cash return, is very similar to the capitalization rate. The main difference between the two is that the cash on cash return considers mortgage payments as an expense. It also replaces the denominator of the cap rate (current market value) with the total cash invested. In that way, real estate investors using a mortgage can accurately compute their return on investment.
Related: Understanding Cap Rate vs. Cash on Cash Return
Does Not Consider Appreciation and Depreciation
Appreciation and deprecation can influence the real estate ROI of rental investment properties. Cap rate, however, does not factor in appreciation and depreciation. Cap rates only focuses on the present, hence using current market value is an important factor.
Not Very Useful for Short Term Rentals
Short term rentals, particularly Airbnb rentals, have been trending in the real estate universe as of late. Airbnb real estate investors won’t find much use from a capitalization rate, however. Why? The net operating income tends to be haphazard with short term rentals. This makes using cap rate as a real estate ROI metric not very practical.
What Are the Uses of Capitalization Rate?
Most real estate investors finance their investment properties with the help of a mortgage. Does this mean that cap rates are useless for these real estate investors? Not at all!
Related: Why Is Cap Rate Used in Real Estate?
Return on Investment Metric
If an investment property is purchased fully in cash, the capitalization rate will accurately project its real estate ROI. What if the property is financed through a mortgage? Cash on cash return will be the better metric to determine the accurate return on investment, but cap rate is still helpful. Regardless of how a property is financed, the capitalization rate gives a good picture of the present return on investment of the property. Typically, the higher the cap rate, the better the property is performing.
Compare Investment Properties
Cap rate isn’t only helpful in understanding a rental property’s profitability. It can also act as an indicator when trying to decide which property to purchase. A quick example can clarify this point.
Imagine we have two rental investment properties: Property A and Property B. Property A’s net operating income is $50,000 with a fair market value of $300,000. Property B has a NOI of $150,000, and its price is $2,000,000. While Property B has a much higher NOI, it is the worse investment of the two. Property A’s cap rate is 16.7%, while Property B’s investment property cap rate is 7.5%. Property B may have more rental income, but the real estate investor of Property A will own a larger percentage of the property and have a higher return on investment.
Estimate Payback Period
The capitalization rate of an investment property can tell you how long it will take to cover the cost of the property, regardless of how it is financed. In other words, cap rate estimates how long it takes until the real estate investor fully owns the property. All that needs to be done is divide 100 by the cap rate of the property. For instance, a property with a capitalization rate of 15% will have a payback period of 6.7 years (100/15).
The investment property cap rate can be a great guiding tool for real estate investors. It does have some limits, as do all other real estate ROI metrics. Therefore, it is best to use multiple metrics when deciding on an investment property.
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