Part 3: Capitalization Rate Formula & What a Good Cap Rate Is (Part 3 of 4)
Cap Rate Formula
Cap Rate = Net Operating Income / Current Property Value
The cap rate formula is the net operating income divided by the property value.
The cap rate formula is calculated on an annual basis. Keep in mind that investors sometimes calculate this differently. The capitalization rate formula can be calculated with or without the occupancy rate, but it’s more accurate using the occupancy rate if you know what that number is.
First, let’s discuss how to figure out the NOI. This is relatively simple to figure out by subtracting the operating expenses from the gross rental income. Next, you need to figure out what the property value is. This is not necessarily the same as the purchase price of the property. For more information on terms used in the cap rate formula, review the key terms section below.
If you decide to incorporate the occupancy rate into your cap rate formula, then you would take the gross rental income, multiply it by the occupancy rate and then subtract your operating expenses.
What Is a Good Cap Rate?
Generally speaking, a cap rate that falls between 4 percent and 10 percent is typical and considered to be a good cap rate. However, it does depend on the demand, the available inventory in the area and the specific type of property. What is a good cap rate can be subjective and various real estate investors with dissimilar investing strategies look at it differently.
For example, a 4 percent cap rate may be the norm in high-demand areas such as in and around large metropolitan areas and high-cost areas like Southern California and New York City. In contrast, a lower-demand area like a rural neighborhood or an up-and-coming neighborhood that is in the process of gentrification, you may see a cap rate of 10 percent or higher.
Typically, buyers want a high cap rate, meaning the purchase price is relatively low in comparison to the NOI. However, a higher cap rate typically means more risk and a lower cap rate represents lower risk. A property with a high cap rate may be located in an area where there isn’t much opportunity for increasing the rent rates or where property appreciation isn’t on a scale with other areas. An investor needs to weigh the risks and determine an appropriate cap rate for their investment goals.
A property with a high cap rate may not take into account the occupancy rate, it may use expected rents and not current rents or it may be in an area where there isn’t much demand for investment properties. Conversely, a property with a low cap rate may be in an expensive area, near downtown and may be considered more desirable and have more demand for that type of property. Keep in mind that you should check how the cap rate was derived so you understand the full financial picture of the real estate investment.
Keep in mind that you should compare apples to apples when deciding if a property has a good cap rate. This means that cap rates should be compared among the same types of properties in similar areas. A multifamily investment property will generally have a much lower cap rate than a commercial building with retail tenants. This makes a multifamily property a lower risk and potentially lower reward investment. This is because people always need somewhere to live and, if the economy takes a turn for the worse, retail tenants are less likely to pay than multifamily tenants.
“The idea of “good” or “bad” cap rates are in the eye of the beholder — the higher the cap rate, usually the higher the risk. In our target markets and asset class, we are seeing cap rates between 5 percent and 6 percent that, when leveraged conservatively, can create cash-on-cash returns of 8 percent to 9 percent
Factors That Affect Cap Rate
A good or bad cap rate can be perceived differently by different investors. Varying cap rates are seen among categories and types of residential and commercial real estate. However, there are a few factors that affect the cap rate like property location and demand in the area.
Factors that typically affect cap rate include:
Location: Property location drives demand and dives the local economy; generally, a more desirable location means a higher fair market value of a property and higher rents, so typically the cap rate remains unchanged
Asset class: This is the type of property such as multifamily, apartment building, industrial or commercial property and typically residential properties have lower cap rates than commercial properties because commercial properties tend to have higher rents
Available inventory: This is how many properties are available in the area and, typically, the lower the inventory, the higher the demand, which tends to lead to properties with lower cap rates
Interest rates: Rising rates typically mean a fall in property values; when rates rise, debts typically rise which decreases net cash flow; this means that rising rates can lead to lower cap rates
“Cap rates have seen downward compression since the Great Recession as U.S. Treasuries have remained steady and the interest rate environment has remained low. That being said, the inverse relationship between cap rates and interest rates will begin to reveal itself as the Federal Reserve moves toward gradually increasing rates.” —