{"id":794,"date":"2018-06-25T10:30:20","date_gmt":"2018-06-25T15:30:20","guid":{"rendered":"http:\/\/www.realtyhop.com\/blog\/?p=794"},"modified":"2022-06-14T11:11:04","modified_gmt":"2022-06-14T15:11:04","slug":"what-is-cap-rate","status":"publish","type":"post","link":"https:\/\/www.realtyhop.com\/blog\/what-is-cap-rate\/","title":{"rendered":"Cap Rate – What Is It and Why Is It Important?"},"content":{"rendered":"

You\u2019re 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.<\/p>\n

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.<\/p>\n

What Is \u201cCap Rate\u201d?<\/h2>\n

The capitalization rate, commonly referred to as the \u201ccap rate,\u201d 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.<\/p>\n

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.<\/p>\n

Cap Rate Formula<\/h2>\n

The most common way to calculate the cap rate is as follows:<\/p>\n

Cap Rate = Net Operating Income (NOI) \/ Property Asset Value<\/b><\/p>\n

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\u2019s asset value is $100,000, your cap rate equation then looks like the following:<\/p>\n

0.63 = $63,000 \/ $100,000 <\/b><\/p>\n

To arrive at a percentage, simply multiply the 0.63 by 100 to receive a 6.3% cap rate.<\/p>\n

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.<\/p>\n

The tables below further illustrate how cap rates are affected by NOI and asset value.<\/p>\n

\n

When NOI changes:<\/p>\n\n\n\n\n\n
NOI<\/td>\n4,000<\/td>\n5,000<\/td>\n6,000<\/td>\n7,000<\/td>\n8,000<\/td>\n<\/tr>\n
Asset Value<\/td>\n100,000<\/td>\n100,000<\/td>\n100,000<\/td>\n100,000<\/td>\n100,000<\/td>\n<\/tr>\n
Cap Rate<\/td>\n4%<\/td>\n5%<\/td>\n6%<\/td>\n7%<\/td>\n8%<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n
\n

When asset value changes:<\/p>\n\n\n\n\n\n
NOI<\/td>\n5,000<\/td>\n5,000<\/td>\n5,000<\/td>\n5,000<\/td>\n5,000<\/td>\n<\/tr>\n
Asset Value<\/td>\n80,000<\/td>\n90,000<\/td>\n100,000<\/td>\n110,000<\/td>\n120,000<\/td>\n<\/tr>\n
Cap Rate<\/td>\n6.25%<\/td>\n5.56%<\/td>\n5.00%<\/td>\n4.54%<\/td>\n4.17%<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n

What Is a Good Cap Rate?<\/h2>\n

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.<\/p>\n

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.<\/p>\n

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.<\/p>\n

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.<\/p>\n

Example of two properties with different cap rates<\/h3>\n

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.<\/p>\n

\n\n\n\n\n\n\n\n\n
<\/td>\n2025 Broadway<\/a><\/td>\n201 E 66th St<\/a><\/td>\n<\/tr>\n
Built in<\/td>\n1977<\/td>\n1961<\/td>\n<\/tr>\n
Estimated Rent<\/td>\n$4,000\/month<\/td>\n$4,800\/month<\/td>\n<\/tr>\n
Asking Price<\/td>\n$710,000<\/td>\n$725,000<\/td>\n<\/tr>\n
Maintenance & HOA<\/td>\n$2,180<\/td>\n$1,471<\/td>\n<\/tr>\n
Cap Rate<\/td>\n3.07%<\/td>\n5.51%<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n

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.<\/p>\n

What Influences a Cap Rate?<\/h2>\n

Anything that affects your potential income or operating expenses will reflect in the property\u2019s 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.<\/p>\n

Location<\/h3>\n

Where you purchase matters. Regarding cap rates, your location affects the rate based on the area\u2019s economic health and market situation.<\/p>\n

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.<\/p>\n

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.<\/p>\n

When buying your property, any high-risk area will increase your cap rate. A high-risk area could include the following:<\/p>\n