As you start looking into rental property investments, one of the first terms you’ll hear is cap rate for rental properties. What is it, how is it calculated, and is it actually a good metric for determining the value of your property?
What is Cap Rate?
The cap rate (or capitalization rate) is the net operating income divided by the market value of the property.
How to Calculate Cap Rate
To calculate the cap rate of a property, you will first need to find the Net Operating Income or NOI. The NOI is the income from rent minus expenses. If you’re looking at a potential property, you can get the income and expense reports from the current owner or you can estimate expenses. You can also contact the county accessor to find the property taxes for a specific property.
Once you have your net operating income, you divide the NOI by the price of the property to determine the cap rate. The more detailed your calculations, the more accurate your cap rate will be. For most properties, an accurate operating cost summary includes property management fees, HOA fees, taxes, insurance, and estimates for maintenance or repairs.
How to Value Real Estate Using Cap Rate
To determine the market value of a property using the cap rate, you will need the cap rate and the net operating income.
To find the market value of a property using the cap rate, determine the NOI and divide it by the cap rate to calculate the market value.
A simple example would be if your target cap rate is 10% and you estimate that the NOI is $10,000 per year. Divide $10,000 by .1 and you get a market value of $100,000.
What the Cap Rate Is Good For?
The cap rate is just one among many metrics and it has many limitations. It’s important not to focus solely on the cap rate when making an investment decision, for reasons that will be explained below.
Cap rates can give you a quick way to compare similar properties, but it’s important to remember that what counts as a good cap rate in one local market might not be a good rate in another local market. It can be useful when you’re comparing similar properties in a single local market. The cap rate can also come in handy in flagging unusual expenses. As you’re digging in to operating expenses to calculate the cap rate, you may notice an unusual cost that could be addressed. For example, an inefficient HVAC system could be raising operating costs dramatically.
Finally, a quick cap rate calculation can also help you understand trends in a local market. If you’re able to get data on cap rates for a specific area for five to ten years back, you can generate a profile that shows you at a glance what profitability is like and whether the trend is up, down, or flat. You must dig deeper before making any decisions, but knowing the trend might be helpful to start.
What Is a Good Cap Rate for Rental Properties?
Some experts use 10% as a standard minimum acceptable cap rate. A lot depends on the area where you’re planning to invest. In a profitable real estate market with steady, growing rental demand, an 8% cap rate might be much better than an 11% cap rate in a market that’s been stagnating for a while.
It’s important never to use the cap rate for rental properties as your only metric for making an investment decision, and especially when considering residential real estate. A better metric to consider is the overall return on investment. After that, the cash-on-cash return can also give some useful data, but, like the cap rate, it doesn’t give enough information to be the sole determiner for any investment decision.
Is Cap Rate a Good Metric for Rental Properties?
Cap rate doesn’t account for appreciation or leverage, which are two crucial metrics you can’t leave out and truly understand the value of a property for investment.
Popularity in Commercial Real Estate
The cap rate is a popular in the commercial real estate market but it is not as useful for single-family rentals. Firstly, commercial real estate doesn’t appreciate as well as residential because it’s based on income, and that income is tied to the consumer price index. Secondly, commercial real estate doesn’t have good leverage compared to residential. Lastly, financing isn’t as good with commercial investments as with residential.
The overall return on investment is the key metric to look at for residential real estate investment. If you want a metric close to the cap rate, use cash-on-cash return instead.
Cap rate and cash-on-cash return don’t account for inflation-induced debt destruction, the hidden wealth creator in real estate investments. They also don’t include the overall lifetime value of your property portfolio and the huge advantage you get from the 1031 tax-deferred exchange, which allows you to reinvest capital without paying tax at the time of sale. That’s in contrast to other forms of investment where you have to pay a significant tax before you can reinvest the money.
There are a few minor areas where the cap rate can be helpful, but overall it’s a flawed metric because it doesn’t consider appreciation and leverage.