Real estate cap rate is a metric often used by investors as a quick and easy way to calculate the return, property value, and net operating income for property investment.
We’ll take a closer look at how to use real estate cap rates, potential drawbacks, and reasons investors may be willing to pay more for a home with a lower cap rate.
- Cap rate measures the annual rate of return from a rental property.
- The 3 variables in the cap rate formula are property value or price, net operating income, and rate of return.
- An investor can use the cap rate formula to solve for any of these 3 variables, provided that 2 are known.
- Factors affecting real estate cap rate include home location and neighborhood, tenant quality, and market potential.
What is a real estate cap rate?
Investors use the capitalization rate (cap rate) in real estate to measure the unleveraged (debt-free) return of a rental property by comparing annual net income to property price or value.
Real estate cap rate can also be used to measure the potential risk or reward profile of similar properties in the same marketplace.
For example, suppose the cap rate of one property is 8%, while similar properties have cap rates of around 6%. An investor can dig deeper to understand the significant variation. The property may be underpriced due to needed repairs, income may be overstated relative to the local fair market rent, or an owner may simply be motivated to sell.
Cap rate formula
The cap rate formula uses 3 variables: net operating income (NOI), property value or price, and rate of return:
- Cap rate = NOI / Property value or price
Provided 2 of the variables are known, the cap rate calculation can be used to solve for the third.
How real estate investors use cap rate
Here’s how to use the formula to find cap rate, NOI, and property value.
Note that NOI is calculated by subtracting property operating expenses from the total rental income collected. Operating expenses do not include mortgage or interest payments, capital expenses or contributions to a capital exchange (CapEx) account, owner expenses, or depreciation.
Rate of return
If a single-family rental (SFR) property has a value of $150,000 and the NOI is $10,000, the cap rate is 6.7%:
- $10,000 NOI / $150,000 property value = .0666 or 6.7% cap rate
This means an investor is generating a return of 6.7% each year, provided that the property value or NOI does not change.
Net operating income
The real estate cap rate formula can be used to solve for net operating income by rearranging the equation. If a rental property has a value of $120,000 and the cap rate for similar properties in the same area is 6%, the NOI should be $7,200:
- Cap rate = NOI / Property value
- NOI = Property value x cap rate
- $120,000 property value x 6% (0.06) = $7,200 NOI
If NOI is greater or less than $7,200, the property may be undervalued or overvalued relative to similar properties. Because no real estate is exactly alike, an investor should dig deeper to understand the variation as part of the due diligence process.
Property value or price
Real estate investors often look for a specific rate of return when searching for rental property to purchase. To illustrate, assume an investor requires a minimum 7% rate of return. Using the cap rate formula, an investor can determine what price to pay for a rental property based on its NOI.
If a rental is generating an NOI of $8,500 per year and a 7% return is required, the most an investor would pay for a property is $121,429:
- Cap rate = NOI / Property value
- Property price = NOI / Cap rate
- $8,500 NOI / 7% (0.07) = $121,429 property price
If an investor requires a minimum 7% rate of return, the maximum purchase price an investor is willing to pay would be a little less than $121,500.
Factors that affect property cap rate
The above 3 examples are relatively straightforward. However, there are several factors to consider that influence real estate property cap rate, along with the NOI generated and a property’s purchase price or value to an investor.
Location or neighborhood
Location is one of the most significant factors to consider. Location can impact the potential rate of return. For example, a home located near high-voltage power lines or one that backs up to a busy roadway may be more difficult to rent.
Understanding the characteristics of a neighborhood also helps an investor determine risks and rewards. The Roofstock Neighborhood Rating is a free online tool that uses a proprietary algorithm to assess neighborhood-specific risks and benefits based on key attributes, such as home values, employment rates, and school district quality.
Age of home
Older homes generally require more repairs and maintenance than newly built homes or those that have been recently renovated and updated. Higher maintenance costs reduce net operating income, which may lower the potential rate of return. That’s one reason new homes typically sell at a higher price compared to resale homes.
A big advantage to purchasing a home already rented to a tenant is that cash flow begins when escrow closes. However, one of the potential risks an investor faces is ending up with a problem tenant.
To give investors peace of mind, every tenant-occupied home on the Roofstock Marketplace includes a copy of the current lease, tenant details, and payment history.
Economic fundamentals in a specific real estate market can affect the current and future value of rental property, such as population and job growth, housing inventory and prices, cost of living and quality of life, and preference of residents in certain areas or neighborhoods to rent rather than own – even if they can afford to buy a home.
Market fundamentals can impact future rent price growth and home appreciation, so some investors may be willing to pay more for less in the short term.
To illustrate, assume an investor is targeting a 7% cap rate but can only find homes yielding a 6% rate of return. According to a recent press release from CoreLogic (March 15, 2022), SFR prices increased by 12.6% year over year.
If an investor believes that rent prices will continue to increase by a similar amount each year, it might make financial sense to accept a lower cap rate at the time of purchase in exchange for a higher potential rate of return in the future:
|Year 1||Year 2||Year 3|
While rent prices in many markets have trended upward over the past few years, past performance is no guarantee of future returns. That’s why investors create customized analyses to explore potential returns using different assumptions before making a purchase decision.
Alternatives to real estate cap rate
While real estate cap rate is a quick and easy calculation, there are some limitations.
First, cap rate assumes a property is (or could be) generating NOI, so the formula is less useful for investors who are fixing and flipping. Cap rate also assumes an investor is paying all cash for a home and ignores the benefits of leverage and cash-on-cash return.
In addition to real estate cap rate, key financial metrics include:
- Cash flow after all rental income has been collected and all bills have been paid, including any mortgage principal and interest (P&I) payments
- Cash-on-cash return comparing the annual return on net pre-tax cash flow received to the amount of cash invested, such as the down payment amount if a property is financed
- Annualized return, also known as internal rate of return (IRR), measuring the annualized net return on equity investment
- Gross yield generated by a rental property divided by the purchase price before deducting any expenses
- Appreciation in equity over the holding period
One question investors sometimes have is whether a cap rate is good or bad. The answer to this question depends on an investor’s required rate of return and the amount of risk an investor is willing to take in exchange for potential reward. A good cap rate is not universal for all investors.
As a rule of thumb, a high cap rate may indicate higher risk, while a lower cap rate may indicate less risk. One of the nice things about investing in real estate is that there is rental property to fit every investing strategy, provided you know where to look.