The capitalization rate, or cap rate, of a property is the amount of money you can expect to get from a property compared to its value or price per year. This includes all the expenses of operating the property but does not include the costs of buying, selling, or financing the property. It is used to estimate the potential profitability of a property as well as compare it with other similar properties.
The net operating income (NOI) is the property’s annual income minus any expenses incurred. For example, if a property valued at 1 million is expected to receive rent income of $50,000 in a year with expenses totaling at $20,000, its net income would be $30,000 ($50,000 - $20,000) and the cap rate would be calculated as
Operating income, or income you get from running the property, is included in the cap rate formula. Sources include:
Operational expenses and maintenance costs are included in the cap rate formula. Examples of expenses include:
Capital expenditures that are long-term investments for the building do not count as operational or maintenance expenses and are not included in the cap rate formula. Instead, they affect the adjusted cost basis of the property.
Cap rate measures a property’s current annual return compared to its current value. It is a similar metric to dividend yield when analyzing a real estate investment trust. A higher cap rate theoretically means a higher return but may come with more risk. For example, a property with risky tenants may have a high cap rate because of the possibility that the tenants will default and leave the property empty.
A lower cap rate usually means that there is less risk, but the potential return is expected to be lower. These are typically very stable properties in high demand areas.
Cap rates also calculates the amount of time needed to recover the amount you originally invested in the property. For example, a cap rate of 5% means that it will take around twenty years to earn back all the money you originally used to invest in the property. Keep in mind that this does not consider the risk involved in the property.
The range of cap rates will differ across different property types, time periods, economic conditions, locations, and many other factors that play a role in determining the price or risk of a property.
A good range for cap rates is between 4% and 12% depending on the area and property type. You can find a more accurate range by researching cap rates for properties similar to yours in the same area. If the cap rate of your property is below that of similar properties, it might be overvalue. If the cap rate is above that of similar properties, the property might be undervalued. Either case is not necessarily good or bad, but they mean that you need to do more research on why the property is being valued the way it is.
Ultimately, a good cap rate for your personal investment will have a wide range depending on your investing strategy, area of purchase, and many other factors. At minimum, your cap rate should be greater than your cost of financing: for example, if you have a 5% mortgage then a property with a cap rate below or equal to 5% is expected to be a money-losing investment.
No. Any expenses related to debt, including the rental property mortgage and interest payments, are not included because the calculation focuses on only the property and not the financing involved in obtaining it. This is the advantage of using cap rates as it does not distract you with debt and assumes using cash, which allows you to focus on the worth of the property without considering complications of accounting for different financing methods that people use.
Property taxes are included in the cap rate calculation, but income taxes are not. This is because income tax rates will differ between owners and situations but property taxes will stay the same.
The main difference between cap rate and yield is that cap rate is a valuation based on current income at current prices whereas yield is based on current income vs your initial investment. Cap rate can change from year to year depending on the valuation of the property while your yield will generally stay the same unless your income significantly changes.
There is an additional type of yield called a levered yield. A levered yield takes into account your costs in financing the property (e.g. mortgage interest costs) and compares the income from the property to your down payment or equity rather than the total cost of the property. This helps you understand how profitable a property is in a more practical context.
For example, let’s say that after financing costs your yield on a $1M property is only 1%, or $10,000. This might seem like a bad investment, but if you only had to put down a down payment of 5%, or $50,000, your levered yield would be 20% a year ($10K/$50K *100%).
The levered yield also helps you consider if a property is unprofitable. For example, a property can have a yield of 4% and seem profitable, but if you have to borrow at 5%, your levered yield would be negative and reflect the fact that you will be losing money on the property.
Return on Investment (ROI) is a measurement of your income from the property compared with its cost. It adds financing costs such as mortgage interest to the cap rate calculation. Accordingly, ROI can vary drastically from buyer to buyer since different buyers will use different financing methods; ROI is more focused on how the investment will affect the individual investor while cap rate is more focused on the property itself.
Cap rate is a quick and convenient calculation to measure how the market values a specific property relative to other similar properties in the area. However, it's only applicable to income-generating properties and can be misleading for properties whose valuations are driven by factors not associated with income potential such as single-family residential homes. The cap rate may not be useful to you if you are simply buying a home to live in without the intent to generate income for it or if you are only focusing on price appreciation potential.
Pros of using the cap rate:
Cons of using the cap rate:
Cap rate is best used as a way to measure the valuation of a property. It allows you to easily compare different properties of the same type without having to consider the complexities of financing. It can point out possibly undervalued or overvalued properties and tell you how the market views a certain property, especially in terms of its risk.
Cap rate is not the best way to measure the potential profitability of a property, however. The levered yield or ROI of a property would be better ways to check a good or bad investment. These take into account your financing costs and better reflect the financial return of a property compared to your investment or down payment.