Cap rates are an excellent tool for assessing a property’s overall profitability. Although it may be difficult to pinpoint a perfect cap rate, there are ways investors can determine if the cap rate of a property meets their individual investment goals. Read on to see how investors can make the most out of their investments using cap rate calculations.
What Is a Cap Rate?
Cap rates can provide helpful information about any property by estimating the expected rate of return on commercial or residential real estate. They are estimates of the rates of return on numerous commercial or residential real estate properties. These rates are computed by dividing the property’s net operating income (NOI) by the asset value of the property.
Cap Rate = NOI / Current Market Value
A property’s cap rate is defined by its potential revenue and risk level compared to other properties. It is important to note that the cap rate will not provide a complete return on investment. It will instead offer an approximation of how long it will take to recover the initial investment in the property.
The most widely used benchmark for comparing investment properties is the cap rate.
Good vs. Bad Cap Rates
A “good” cap rate varies depending on the investor and the property. Generally, the higher the cap rate, the higher the risk and return. Market analysts say an ideal cap rate is between five and 10 percent; the exact number will depend on the property type and location. In comparison, a cap rate lower than five percent denotes lesser risk but a more extended period to recover an investment.
Investors should spend some time thinking about a reasonable cap rate for the properties in their portfolio. Utilizing the cap rate formula can help investors immediately eliminate properties that don’t fit their risk threshold by having a desired rate in mind.
What Affects a Property’s Cap Rate?
According to J.P. Morgan Investment Banking, Cap rates usually reflect more prominent economic factors. These factors include:
- Interest rates – High inflation and the ensuing increases in interest rates can impact commercial real estate cap rates; when interest rates rise, cap rates quickly follow suit.
- Rent growth – When there is a prevalent expectation of higher rents and NOI, this can lead to a noticeable increase in interest rates. A declining economy can also put pressure on cap rates to rise and halt rent growth.
- GDP and unemployment – GDP and unemployment both indicate the state of the economy. Commercial real estate investments tend to have lower cap rates when GDP is high and unemployment is low. Investment properties carry a higher risk when GDP is low and unemployment is high.
- Location – Cap rates are influenced by the location’s vicinity to highways, public transportation, popular city locations, etc. Properties in a stable location in an area with high demand typically have lower cap rates.
How to Utilize Tools To Value Property
The cap rate of a property is not the only metric used to assess a real estate investment. Investors should examine the return on investment (ROI), internal rate of return (IRR), and gross rent multiplier (GRM), as well as several other considerations, such as the property’s unique attributes and location.
What Is Cap Rate Compression?
Cap rate compression refers to growing market prices for investments concerning the income generated by the investment. In summary, cap rates are inversely connected to market pricing; hence, when cap rates are compressed, prices rise without a corresponding increase in rental income. According to supply and demand rules, cap rate compression may come from excessive investor demand or a general lack of quality inventory, resulting in higher pricing for the same assets.
Cap rate compression is largely indicative of market recovery. Location, sector shift, and economic environment are three factors that have historically driven cap rate compression.
Takeaway
Cap rates are forward-looking, and each transaction is influenced by a building’s potential, the investor’s perspective regarding the property, and the current economic conditions and expectations.
FAQs
That said, many analysts consider a "good" cap rate to be around 5% to 10%, while a 4% cap rate indicates lower risk but a longer timeline to recoup an investment.1 There are also other factors to consider, like the features of a local property market, and it is important not to rely on cap rate or any other single ...
What is considered a good cap rate for rental property? ›
A “good” cap rate varies depending on the investor and the property. Generally, the higher the cap rate, the higher the risk and return. Market analysts say an ideal cap rate is between five and 10 percent; the exact number will depend on the property type and location.
What does a 7% cap rate mean in real estate? ›
The cap rate is an asset's unlevered (no mortgage) return, and a reflection of an asset's relative risk. If the buyer were to purchase the property all cash in the example above, and if the property distributes the same net operating income, the buyer would receive a 7% return on their investment.
Do investors want high cap rate? ›
It's generally better to have a lower cap rate than a higher one. A lower cap rate implies that the property is more valuable and less risky due to type, class, and market. While a higher cap rate offers investors a higher return, that property investment typically has a higher risk profile.
What is the 2% rule for cap rates? ›
This is a general rule of thumb that determines a base level of rental income a rental property should generate. Following the 2% rule, an investor can expect to realize a gross yield from a rental property if the monthly rent is at least 2% of the purchase price.
Is 7% a good cap rate on a rental property? ›
In real estate, a low (less than 5%) cap rate often reflects a lower risk profile, whereas a higher cap rate (greater than 7%) is often considered a riskier investment. Whether an investor deems a cap rate “good” is a direct reflection of whether or not they think the investment's return matches its perceived risk.
What is the 50% rule in real estate? ›
The 50% rule is a guideline used by real estate investors to estimate the profitability of a given rental unit. As the name suggests, the rule involves subtracting 50 percent of a property's monthly rental income when calculating its potential profits.
What is a realistic cap rate in real estate? ›
Investors hoping for deals with a lower purchase price may, therefore, want a high cap rate. Following this logic, a cap rate between four and ten percent may be considered a “good” investment. According to Rasti Nikolic, a financial consultant at Loan Advisor, “in general though, 5% to 10% rate is considered good.
Is a 20% cap rate good? ›
In general, people tend to agree that a “good” cap rate can be anywhere from 5-10%, but even this should depend on your risk tolerance, the specific asset class, and your ideal time horizon for the investment. So while cap rates can be useful, they should never be the only metric you should consider.
What is a cap rate for dummies? ›
The cap rate is defined as the ratio between the net operating income (NOI) produced by an asset and its market value, thus constituting the rate at which the NOI is capitalized to derive the price of the asset.
There is no single value for what makes an "ideal" capitalization rate, and investors should consider their own risk appetites when evaluating a property. Generally, a high capitalization rate will indicate a higher level of risk, while a lower capitalization rate indicates lower returns but lower risk.
Is cap rate better than ROI? ›
Cap rate tells you what the return from an income property currently is or should be, while ROI tells you what the return on investment could be over a certain period of time. If you're considering two potential investments, the one with the higher cap rate could be the better choice.
What are the disadvantages of cap rate? ›
It doesn't account for debt: The cap rate doesn't take into account the impact of debt on an investment property. If the property is financed with a mortgage, the cap rate doesn't account for the interest payments or the impact of leverage on the return.
What is the current cap rate? ›
The average cap rate increased from 6.4% to 7% in H2 2023, with expansion across multiple property types.
Does cap rate determine property value? ›
Cap rates which are determined by evaluating the recent actions of buyers and sellers in a particular market place will produce the best market value estimate for a property. If you are able to obtain a market cap rate, you can then use this information to estimate what similar income properties should sell for.
Why is a high cap rate bad? ›
In general, a higher cap rate suggests that the market perceives the property to be a riskier investment with less stable cash flows. A high cap rate may be due to a number of factors, such as lower demand for the property type or location, higher vacancy rates, higher expenses, or lower rental rates.
What is the 2% rule in real estate? ›
The 2% rule is a rule of thumb that determines how much rental income a property should theoretically be able to generate. Following the 2% rule, an investor can expect to realize a positive cash flow from a rental property if the monthly rent is at least 2% of the purchase price.
Is 12 a good cap rate for rental property? ›
Cap rates between 4% and 12% are generally considered good, but it's important to remember that other factors, such as potential improvements, should also be considered when evaluating a property. Cap rate does not account for changes in cash flow due to improvements or renovations, and it does not consider leverage.
