Cap Rate: A Must-Have Number for Rental and Commercial Investors (2024)

If you’re new to real estate investing, you may feel overwhelmed and wonder how to determine which properties to buy. Optimally, you’d like to get a handle on which investments will be the most profitable before jumping in—and you can—by understanding how to calculate cap rate.

Calculating the market cap rate, or capitalization rate, is hands down the best place to begin, especially for real estate investors.

What is a Cap Rate?

A cap rate is an annual return from operations that an investor expects to receive for a certain asset in a specific market at the current time if the asset were to be purchased for all cash.

A cap rate helps indicate the rate of return that investors will most likely generate on an investment property.

While there are several ways to estimate the market value of an investment property, many common options fall short because they fail to consider important variables such as capital expenses, deferred maintenance costs, market factors, and debt terms. This is why one of your main rental analysis tools should be the cap rate.

Still, when calculating an investor’s potential return, it’s important to recognize that the cap rate has limitations. For instance, it does not consider the time value of money and future cash flows, account leverage, and other real estate metrics. It’s also somewhat ambiguous because there aren’t concrete numbers for “good” and “bad” cap rates. Rather, the cap rate is an effective way to quickly weigh an investment against another to calculate which will produce a better return on investment (ROI) within the context of a particular real estate market.

How to Calculate Cap Rate

For example, you’re at a local real estate meet-up, and someone presents you with an off-market deal.

“This won’t last long. It’s priced to sell. You better jump on it!” they say.

It sounds great. But is it really a good deal? Here’s where you begin your assessment.

The most widely used cap rate calculation formula is simple:

Cap Rate = Net Operating Income (NOI) / Current Market Value

You can also turn this formula around to calculate other variables.

Want to know what you should pay for a property?

Net Operating Income / Cap Rate = Value

Curious about what your net operating income will be?

Value x Cap Rate = Net Operating Income (NOI)

For these cap rate calculations, keep in mind that:

• The net operating income (NOI) is the annual income generated by the property, which can be calculated by deducting the operating expenses associated with the property, including upkeep and maintenance costs and property taxes.
• Current market value refers to the property value according to current market rates.

While some calculations for cap rate use purchase price instead of current market value, this version has limitations regarding property prices for old properties whose purchase amounts skew very low, as well as inherited properties (where the purchase price is zero).

Cap rate as a measure of risk

The cap rate can also be used as a way to estimate risk. A higher cap rate usually implies a lower prospect of return on investment and, thus, a higher level of risk. In contrast, a lower cap rate can mean a better valuation and a lower level of risk.

Does this mean it’s better to go for a lower-risk investment (lower cap rate) or a higher-risk investment (higher cap rate) that may have a better potential for a higher return on investment? Unfortunately, the answer isn’t cut and dry as with most investment decisions. Rather, the relative value depends on your personal investing goals, tolerance of risk, and many other real estate metrics. Because of this, when evaluating investment rental properties, it’s important to view capitalization rates as only part of the equation.

Cap rate example

To give you a cap rate calculation example in everyday terms, imagine a seller’s asking $600,000 for a 10-unit apartment’s purchase price, and the net operating income (NOI) is $30,000 annually. Your calculation expressed as a percentage will look like this:

$30,000 / $600,000 = .05 = 5%

That is a 5 percent cap rate. Most historical standards consider this a high price and low cap rate for assets in most markets.

You may decide that you don’t want to pay $600,000. Instead, you determine to make a 7% annual return (cap rate) on your rental property investment and buy for cash.

What should you pay? Simply plug in the appropriate figures to determine the value:

$30,000 / .07 = $428,571

Notice that the move from a 5% cap rate to a 7% cap rate is a wide swing in price, from $600,000 to $428,571. The denominator in this equation causes a large fluctuation in the outcome.

In other words, a small change in capitalization rate can cause a significant change in value.

Also, note that even if there’s $30,000 in annual net operating income (NOI), it doesn’t mean you’ll pocket that much. There may be capital expenses and other items to consider, most notably debt service if you take out a loan.

The principal and interest rates on a loan of this size could be a few thousand per month, consuming most of an investor’s expected cash flow. But if that’s true, why would you use debt anyway?

Some property investors might choose that route because leverage could allow them to buy more property for the same amount of cash. And it could multiply the appreciation received on an asset.

Although I’ve been a commercial real estate investor for many years, I’m still surprised sometimes when I calculate the power of debt with regard to increasing the value of equity.

What is the formula for a cap rate?

The formula for a capitalization rate is calculated by dividing a property’s net operating income (NOI) by its current market value. The property’s cap rate is typically expressed as a percentage and measures the rate of return on a real estate investment.

The cap rate indicates a property’s income potential relative to its value in the market. This helps real estate investors assess the profitability and risk associated with a property.

What is a Good Cap Rate in Real Estate?

Through the late 1990s, investors looked at about 10% as the benchmark cap rate for commercial real estate assets as a whole. Today, average cap rates for multifamily and other real estate investments run from 4%-7%, and 10% is a distant memory.

The massive influx of capital chasing multifamily deals have driven cap rates down to historically low levels, meaning prices are at historically high levels. Once you shop for and evaluate property investment deals, you will become familiar with a good or bad cap rate in your local market.

Which Factors Determine Cap Rate?

The essential aspects determining a property’s capitalization rate include its location, condition, market demand and trends, rental income potential, and prevailing interest rates. In desirable locations with high demand, cap rates tend to be lower, reflecting a higher property value and the potential for a stable expected growth rate in rental income.

Conversely, less desirable locations or rental properties with lower income potential may have higher cap rates. Property condition also plays a role, as well-maintained properties are generally more attractive to a real estate investor. Market conditions and interest rates can also influence cap rates, with lower interest rates typically leading to lower cap rates and vice versa.

U.S. multifamily cap rate history

Below is a chart showing large multifamily cap rates from 2002 to 2018. Remember that this is for large transactions, and these big players can often endure more compressed cap rates than you’ll want to consider.

The averages above include newer, more stabilized assets than you may be looking to buy, which likely means you will be taking on more risk, more potential maintenance and repairs, and a chance for higher vacancies. All this translates into a higher cap rate (lower price) for your transaction.

In your evaluations, you may also quickly realize that broker estimates of cap rates differ from actual cap rates. Brokers sometimes base the cap rate on a pro forma (theoretical) operating statement. This means they calculate what the property will be making once you buy it (for an inflated price and after implementing successful marketing and management changes).

You can draw your own conclusions, but I recommend you rely heavily on past performance (what is) over future projections (what can be). Be careful; it’s easy to get fooled in this way.

That said, if you have definitive changes that you can make to an asset to quickly improve the property’s net operating income, this can be an offsetting factor.

For example, my firm, Wellings Capital, acquired a 125-unit townhome community in 2017. We knew the water and sewer expenses were over 100% too high.

Through our due diligence process, we discovered the culprits. To improve the situation, we planned to install water meters on individual units, fix the leaks (stemming from worn toilet flappers and pools), then pass the water bills on to the tenants.

We took these steps after the acquisition, cutting our water bill in half, as planned, adding about 10% to our bottom-line income.

Other Methods of Analyzing Properties

As I previously mentioned, several other ways exist to evaluate properties before investing. I’ll briefly describe three of the most common and explain some of their benefits and shortcomings.

Price per unit

The price-per-unit option is popular for its simplicity. The average newbie investor can quickly compare apartments at $50,000 per unit to others at $90,000. And many investors know the cost of newly built apartments (typically over $100,000 per unit all-in).

But this method fails to consider several of the most important elements in real estate investing, such as revenue, expenses, deferred maintenance, and other capital expenses.

The neighborhood and the economy are not taken into account either. Overall, this is an ineffective way to evaluate the property asset value of a multifamily investment property.

Is $50,000 per door a good deal in your hometown? Is $150,000 a bad deal?

It’s possible that $50,000 is a bad deal, or $150,000 is a great deal! There’s much more you need to know before making a judgment.

Gross rent multiplier (GRM)

When I first began real estate investing, I heard that the gross rent multiplier (GRM) is useful for evaluating rental property value. The GRM is simply the property price divided by the annual gross rent.

For instance, if a 30-unit multifamily property was priced at $1.5 million and the gross annual rent was $243,000.

The GRM would be:

Price / Gross Annual Rent = Gross Rent Multiplier

$1,500,000 / $243,000 = 6.2

A broker may tell you this is an excellent deal because your market’s “average” GRM is seven or above. But not so fast!

The GRM fails to consider expenses, deferred maintenance, market factors (supply and demand), and property type. The GRM also assumes that you know the accurate gross income of this property and the other similar properties in the market. Realistically, it’s challenging to be certain using the GRM.

Brokers will also often try to apply the GRM at full occupancy with no concessions. However, any number other than the actual gross rent renders the ratio meaningless. Personally, I’m not a fan of the GRM.

1% rule

I heard about the 1% rule before I ever considered buying a property. This rule of thumb states that the per-unit rent should be at least 1% of the cost per unit.

Therefore, a property priced at $75,000 per unit should be rented for at least $750 per unit. This is perhaps the most well-known metric on Main Street. But like those above, I wouldn’t use it (except as a preliminary guesstimate when initially hearing about a property for sale).

The 1% rule can indicate that the property is priced in line with revenue projections—but not much more. This ratio tells you nothing about operating expenses, deferred maintenance, capital expenses, or debt terms. It won’t help you figure out if it’ll be a good cash-flowing property for you.

As you can see, these methods are somewhat faulty measuring sticks. This is why I propose adopting the cap rate as one of your main analysis tools.

Why Use Cap Rate?

The price per unit, GRM, and 1% rule are less efficient evaluation metrics than the cap rate calculator. This is because the cap rate:

• Accounts for both revenue and expenses
• Indicates the supply and demand for a particular asset type in a certain location at a specific time
• Reflects the asset grade (new Class A rates are often about a point below Class B)
• Can have a connection to the interest rate on debt
• It is widely used as a standard metric by most operators, investors, and brokers

Much can be said about using the cap rate to calculate property investments. This can be a much longer discussion, but I’ll briefly address some FAQs about cap rates.

Frequently Asked Questions About Cap Rates

Can the cap rate become so low that the asset won’t cash flow?

This can happen—especially when using debt and competing against the big players in primary cities. You can calculate this by factoring in the net cash flow, including debt service, deferred maintenance, and necessary capital improvements.

Why would a REIT or life insurance company buy an asset at a 3 to 4 percent cap rate?

Some institutional investors buy for cash or with low debt and love the stability and predictability of buying in gateway cities like New York, Boston, L.A., and San Francisco. These assets have additional relative property values due to the local market’s steady demand and rent growth. These buyers can endure low returns in exchange for stable income and likely appreciation. I recommend that you don’t play in their sandbox.

Is a high cap rate always a good deal?

If you hear about the sale of a property at a 10-cap, it may sound like a screaming deal. But you get what you pay for. There is likely a reason that it is selling so cheaply.

Perhaps the operating statement is misrepresented. Perhaps it is a C- or D-class property in a high-crime (possibly high-risk) area. Maybe there are environmental hazards or other reasons the seller wants to dump it quickly. Buyer beware!

I heard the cap rate is what it is. You can affect income but can’t affect the cap rate in the value formula (Income / Cap Rate = Value). Is that true?

While this is often true, there are tactics that can be used to compress the cap rates of certain asset types in specific situations. Our Wellings Capital funds are invested with operators with strategies and proven track records of buying assets (like self-storage facilities) from mom-and-pop owners; making significant enhancements to marketing, operations, and income results; and selling to REITs or other institutional buyers.

By doing this, these operators have achieved significant cap rate compression when selling these assets. This results in substantial asset appreciation and almost unbelievable equity growth combined with the careful use of leverage.

Can cap rates change?

Yes, cap rates can change. Cap rates are influenced by various factors such as market conditions, supply and demand dynamics, economic factors, and investor sentiment. Shifts in any of these factors can lead to changes in cap rates. For example, if there is an increase in market demand for real estate, cap rates may decrease as investors are willing to pay higher prices for properties.

On the other hand, if there’s a decrease in demand or rising interest rates, cap rates may increase as investors seek higher returns to compensate for more risk or reduced profitability. Therefore, cap rates are not fixed and can fluctuate over time in response to market conditions and other relevant factors.

Is a higher cap rate better?

Whether a higher cap rate is better depends on the investor’s specific goals and preferences. A higher cap rate implies a higher potential rate of return on investment, which can appeal to some investors seeking immediate cash flow or higher yields. It may also indicate a property with higher risk or lower market demand.

Conversely, a lower cap rate may suggest a more stable property in a desirable location with potentially lower immediate returns. Ultimately, assessing a good cap rate depends on the investor’s investment strategy, risk tolerance, and particular objectives. There’s no one-size-fits-all answer to whether a higher cap rate is good, as it depends on individual circ*mstances.

Is cap rate the same as ROI?

No, the capitalization rate differs from the return on investment (ROI). The cap rate is a ratio that measures the relationship between the property’s net operating income (NOI) and its current market value. It provides a snapshot of the property’s income potential relative to its value.

In contrast, ROI calculates the overall return generated by an investment, considering the initial investment cost, ongoing expenses, and any income generated over a specific period. ROI is a more comprehensive measure that considers the total investment picture, including beyond only the property’s generated income. While cap rate focuses on income and value, ROI provides a broader perspective on investment performance.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.