Part 2 : Capitalization Rate Formula & What a Good Cap Rate Is (Part 2 of 4)
When to Use the Cap Rate
You should use the cap rate as a way to evaluate a real estate investment. It’s typically used prior to purchasing a property but can also be used once you already own the property and before you put the property on the market to sell it.
The capitalization rate is a tool to help you evaluate a property and should be used by investors in addition to other tools. Typically, a buy and hold investor will use the cap rate as well as landlords and commercial investors. It makes sense to use the cap rate on residential and commercial properties that are currently rented.
The cap rate can be used for:
Single-family investment properties
Condo and townhome rental properties
Landlords who want to evaluate a property they already own and may consider selling
When Not to Use the Cap Rate
There are certainly many scenarios when using the cap rate formula is appropriate. However, there are times when using the capitalization rate doesn’t make much sense. You shouldn’t use the cap rate if you’re a fix and flipper or if you’re buying a vacant property.
Typically, you shouldn’t use the cap rate for the following scenarios:
Fix and flip: Fix-and-flip investors purchase real estate with the intention to rehab it and sell it quickly for a profit, so they don’t use the capitalization rate to determine if the property is a good investment. They’re not interested in the rental income because their exit strategy is selling the property and not renting it out.
Purchasing land: When evaluating land, an investor doesn’t usually use the capitalization rate because the land typically is vacant and, therefore, doesn’t have any rental income so the NOI can’t be calculated. Instead, the investor should research the land thoroughly, including its current and allowed zoning, which is important if you want to resell the land. You should also research the utility accessibility and do a survey of the land, so you know what you’re buying. For more information on how to buy and evaluate land, read our in-depth guide on how to buy land.
Purchasing a vacant or unoccupied property: The cap rate formula depends on NOI, so it generally shouldn’t be used if the property is vacant because it doesn’t have any rental income to take into account. Although some investors use projected rental income, it’s not very common because it may be inaccurate, and it’s difficult to estimate expenses on a vacant property.
Purchasing a vacation rental property: Although a vacation rental property is rented and will have NOI and operating expenses, it skews the results of the capitalization rate formula because it’s not rented year round. Part of the year, the owner will use the property as a vacation home, so a cap rate doesn’t give the property an accurate representation of value.
Short-term rental property: Similar to a vacation rental property, a property that offers short-term rentals also skews the cap rate because the rental terms are generally for days or weeks and a cap rate is calculated annually.