Part 1: Capitalization Rate Formula & What a Good Cap Rate Is (Part 1 of 4)
A capitalization rate, or cap rate, is used by real estate investors to evaluate an investment property and show its potential rate of return, helping decide if they should purchase the property. The cap rate formula is cap rate = net operating income/current property value. A good cap rate is typically higher than 4 percent.
What a Cap Rate Is & How It Works
A cap rate is a formula that investors often use as a tool to evaluate a real estate investment based off of a one-year period. It should be used to help determine if the property is a good deal. Instead of solely using the cap rate to determine if you should buy an investment property, we recommend using it as one of a few different evaluation tools.
The cap rate is calculated based on annual returns. This means that if a property performed well or poorly for one year, this shows up in the cap rate calculation. It also means that an investor isn’t getting an overview of the property for the past several years. It’s important to keep in mind that the cap rate shows the rate of return over one year, so if the property had prior years of poor performance, the cap rate might be deceiving in that is only shows one positive year of returns. It’s just something to keep in mind as you analyze the investment property further.
The cap rate is generally used by long-term investors that are purchasing residential or commercial rental property. Fx and flippers do not use it because they don’t intend to rent out the property. Cap rates should be compared to similar properties in the same asset class.
The capitalization rate is the ratio of net operating income to property asset value. The cap rate doesn’t take into account your mortgage payments or the costs associated with purchasing the property like lender fees and closing costs. That’s why, along with the cap rate, you should look at the overall financial picture of the investment property including its return on investment (ROI), cash flow and what comparable properties are selling and renting for.
Why a Cap Rate Is Important
A cap rate is an important tool for investors because it helps them evaluate real estate based on its current value and its net operating income (NOI). It gives them an initial yield on an investment property. An investor can look at a rising cap rate for a property and see that there’s a rise in income relative to its price. In contrast, a fall in cap rate generally indicates that there is lower rental income compared to its price. They can look at the cap rate before deciding if the property is worth buying or not.