Tips & AdviceCap Rate - What Is It and Why Is It Important?

Cap Rate – What Is It and Why Is It Important?

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You’re deciding between a few options when purchasing a piece of property to rent it out and generate rental income. In this case, you will be wise to compare the cap rates between the two properties to understand the associated risk in moving forward with either.

While purchasing property, you operate under the assumption that your asset will appreciate by the time you decide to sell. However, to best understand the potential risks and benefits of several options, you will refer to various metrics like a cap rate to draw stronger conclusions. Continue reading to learn more about what a cap rate is and how to calculate and interpret that information to aid in your decision-making process.

What Is “Cap Rate”?

The capitalization rate, commonly referred to as the “cap rate,” measures the rate of return on a real estate investment property based on the income it generates. It explains how much an investor can potentially make or lose from their investment property. A formula produces the exact cap rate, but that number serves simply as a prediction of the amount of money an investor can receive; it is not a concrete number. Additionally, cap rates are subject to change based on several variables, explained further below.

While cap rates are commonly used when exploring the potential for commercial real estate, RealtyHop displays the cap rate for residential properties for investors looking to generate income from a residential home. Furthermore, even buyers who plan to occupy their home as their primary residence can utilize a cap rate to determine the risk associated with their purchase.

Cap Rate Formula

The most common way to calculate the cap rate is as follows:

Cap Rate = Net Operating Income (NOI) / Property Asset Value

In the above equation, the net operating income (NOI) refers to the expected generated annual income after deducting all expenses. If you acquire a property you intend to rent out all year; you may expect to make $75,000 from rental income. However, if you spend $1,000 a month ($12,000 a year) to keep the property in liveable condition, you will deduct $12,000 from $75,000 to arrive at an NOI of $63,000. Now, suppose your property’s asset value is $100,000, your cap rate equation then looks like the following:

0.63 = $63,000 / $100,000

To arrive at a percentage, simply multiply the 0.63 by 100 to receive a 6.3% cap rate.

Cap rates can change for the same property depending on NOI and asset value shifts. The below two tables demonstrate the relationship between a shifting NOI or asset value and the cap rate of a speculative asset.

The tables below further illustrate how cap rates are affected by NOI and asset value.

When NOI changes:

NOI 4,000 5,000 6,000 7,000 8,000
Asset Value 100,000 100,000 100,000 100,000 100,000
Cap Rate 4% 5% 6% 7% 8%

When asset value changes:

NOI 5,000 5,000 5,000 5,000 5,000
Asset Value 80,000 90,000 100,000 110,000 120,000
Cap Rate 6.25% 5.56% 5.00% 4.54% 4.17%

What Is a Good Cap Rate?

The average cap rate falls between 4% and 10%, but there is no standard indicator of a good or bad rate. Cap rates vary by market conditions, location, and property characteristics. Depending on your intent, you may want to purchase a property with a high cap rate or vice versa. Therefore, you should consider your financial goals and know how you will use the property to achieve them. Your goals, combined with the knowledge about cap rates in your area, will help you decide on an ideal cap rate for your situation. You can then confidently compare cap rates across comparable properties.

Generally speaking, a low cap rate means the investment has low risk. A more conservative investor may seek a property with a lower cap rate as this indicates that while you may not make a ton of money from monthly rental income, your property will appreciate. You can then sell it for a high price down the line. If you plan on holding onto your investment for some time and are not in a rush to see returns, this safer option proves optimal.

A high cap rate indicates a higher risk. Some investors may welcome this higher risk because they want to make as much profit as possible and recoup their investment quickly. Since the purchase price influences the cap rate, a high cap rate can signify a good deal on a piece of property. If a buyer finds a property at a competitive to low price point, it may have a higher cap rate. A higher cap rate indicates that a property will return high income in a short amount of time but likely not appreciate greatly in value.

It is important to note that while investors primarily use cap rates when comparing potential investments, a buyer who plans to occupy a property as their primary residence can also use information about cap rates to understand the risk associated with their purchase. A homeowner may take comfort in knowing that their home has a lower cap rate as it means they will likely see their home value appreciate over time.

Example of two properties with different cap rates

The following table illustrates how NOI and purchase price influence the cap rate and what this means for a potential buyer. Both properties have one bedroom, reside in Manhattan, and have a similar purchase price. 2025 Broadway has a lower anticipated monthly rental income and higher expenses than 201 East 66th St. Therefore, 2025 Broadway has a lower cap rate, and it will take a buyer longer to recoup their investment.

2025 Broadway 201 E 66th St
Built in 1977 1961
Estimated Rent $4,000/month $4,800/month
Asking Price $710,000 $725,000
Maintenance & HOA $2,180 $1,471
Cap Rate 3.07% 5.51%

By comparing the two properties together, a potential buyer can understand the key financial differences between each unit and therefore make a more informed decision based on their goals.

What Influences a Cap Rate?

Anything that affects your potential income or operating expenses will reflect in the property’s cap rate. A cap rate reflects various components like the current market conditions of your local community, the type of property you purchase, and the national economy.

Location

Where you purchase matters. Regarding cap rates, your location affects the rate based on the area’s economic health and market situation.

If you purchase a property in a metropolitan area, you will typically see lower cap rates. This is because many renters occupy the area, so properties rent quickly, making it less risky for you as an investor. When purchasing in a remote location with a less robust economy, investors may look for higher cap rates to compensate for the higher risk they take in this area. This property may have a high NOI due to low monthly expenses, but it will not greatly appreciate over time.

Furthermore, investors should use cap rates to compare properties in the same area. A property with a cap rate of 7% in New York City is different from a 7% cap rate in a small town, and comparing the two will not provide fruitful conclusions regarding where to invest.

When buying your property, any high-risk area will increase your cap rate. A high-risk area could include the following:

  • Property susceptible to storms: think flood zones, Tornado Valley, hurricane-prone areas, etc. If your property can easily render damages from a storm, it may affect the overall value of your home, and it will fail to increase over time.
  • Area with a higher crime rate: for similar reasons as those homes susceptible to storm damages, properties in an area with a high crime rate may generate income monthly but likely not appreciate over time.

Type of Property

The type of property and amount of potential tenants affect the cap rate. A smaller property, like a single-family home or duplex, has a high level of risk as one tenant greatly affects your NOI. Half of your rental income dissipates if one person does not rent in a duplex, increasing your cap rate.

On the other hand, multi-family homes or large apartment complexes have less risk when it comes to tenant occupancy because you can afford to have an empty unit for a longer time. This type of building is less risky since there are more opportunities to increase your NOI and the loss of one tenant’s income grows proportionally smaller as the amount of tenants increases.

Market Condition

The state of the real estate market influences a property’s cap rate, as a healthy market with activity tends to decrease cap rates. In a slower market with less purchasing activity, cap rates increase. Purchasing in a slower market comes with more risks to investors, and the higher cap rate represents that condition.

Additionally, the market size can impact cap rates as well. In a heavily populated area with more buyers, cap rates will decrease as the property will likely appreciate. An area with fewer buyers creates more risk for the investor, and their property will likely not increase over time. This condition ties back to the location, as a more heavily populated area typically has a higher number of buyers than a location with a lower population.

Interest Rates

Interest rates also impact cap rates as they directly correlate to a real estate market’s condition. As of the summer of 2022, interest rates are around 5%, which is 2% higher than in 2021. The increase in interest rates is a response to last year’s hectic market, where a housing shortage established heavy competition between buyers, who often engaged in bidding wars to purchase properties, sometimes sight unseen.

Therefore, higher interest rates, combined with increasing housing prices, limit buyers’ purchasing power and decrease the number of real estate transactions. Overall, this interest rate increase slows the market and will likely increase cap rates. Investors can use this information to understand why current cap rates are higher than they may typically expect.

Why Is It Important to Me as A Buyer?

Buyers can use cap rates to understand the possibility of a return on their investment. While cap rates are essential to investors seeking to rent out their property and generate income, seasoned home buyers or even first-time homebuyers can also look at cap rates to consider their property’s long-term potential. Since a cap rate explores the potential for a home’s appreciation, homebuyers may want to buy a property with a low cap rate for the area as this means it will generate income when it comes time to sell.

In today’s market, investors can look to the future and consider long-term returns when considering which property to buy. As analysts predict an incoming recession over the next year, investors who plan to rent out their property may find solace in the idea that more people rent during a recession. Therefore, they may purchase a property with a higher cap rate as they plan to use the rental market to recoup their investment, situating themselves amid activity.

If you intend to live in your property and are not looking to generate rental income, you may look at cap rates for the next year, understanding that they will increase as the market slows down. Therefore, you will not feel as anxious about the increase as you know what causes it, helping you feel more confident about your purchase.

First-time homebuyers can understand more about the housing market by looking at cap rates and therefore make more informed decisions about their property. Under the assumption that their first home will not be their last, a first-time homebuyer can compare a few potential homes and understand that the lower the cap rate, the less risky it would be to acquire the home. While you may not be able to generate rental income, odds are the property will appreciate and produce a profit when you decide to sell. To ensure that you make a sound investment, you can refer to the property’s cap rate and gain a sense of the home’s overall value.

Conclusion

Investors actively use cap rates to compare potential properties in the same market. Those who look to rent out the property can adopt various investment strategies and therefore seek a specific cap rate range to achieve their financial goal.

Since so many factors influence the cap rate, it is a substantial indicator of potential income. RealtyHop lists cap rates for most properties based on over a decade’s worth of data.

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