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Buying Tips

What Is a Good Cap Rate

Blaine Annett
I
December 9, 2021

What is a Good Cap Rate?

 

Cap rates, also known as capitalization rates, are among the most crucial indicators to determine whether an investment property is worth considering. Cap rates are a vital indicator for determining whether a property is worth picking up for real estate investing. It's not surprising that they have been instrumental in creating some of the most successful real estate portfolios today. You can't build a portfolio that's even half-decent without asking, "What is a good cap rate?" It is so important. It is in your best interests to learn more about what is a good cap rate and how you can use them to improve your investment efforts.

 

What is a Cap Rate?

 

A cap rate is one of the most reliable and easy ways to determine whether a real estate investment deal is worth pursuing. In its simplest form, a cap rate is an equation that will determine how much an investor will make or lose if the property is purchased. It is important to note that they  will not give investors an exact amount they could gain but only an estimate. While more accurate than stock market forecasts, cap rates are still estimates and subject to error. Cap rates do not always accurately reflect the potential return of an investment. However, it is vital to use diligence and attention to detail to estimate the cap rate accurately.

 

Cap rates should not be used as a standalone measure. They should be used with other metrics. A cap rate is nearly useless by itself. A cap rate can be used with additional data or information to reduce an investor's risk during an investment. This is the beauty of knowing how to calculate cap rates: The resulting number can minimize risk more than most investors realize. Knowing how much money an investment can potentially bring in will help determine whether or not you should make the purchase.

 

What is a Reasonable Cap Rate for a Rental Property?

 

A reasonable cap rate is around 4%. However, it's important to distinguish between a "good" and "safe" cap. The formula calculates net operating income (NOI) relative to the initial purchase price. High cap rates may be desirable for investors looking for lower purchase prices. A cap rate of between 4-10% may be considered a good investment. Cap rate is a vital indicator of the property's profitability for property investors. A property with a higher cap rate is better for investors who need to cover the purchase cost quickly.

 

Capitalization rates are also synonymous with risk evaluation. They help determine how much of a risk there will be. A lower cap rate means you are less likely to be exposed, while a higher rate is more likely to have some risks. Therefore, investors looking for a safer option will prefer properties with lower cap rates. However, it is essential to remember that you shouldn't take on more risk than your ability to bear and that cap rates should be used with other calculations.

 

What is Cap Rate, and Why is it so Important?

 

Investors use the cap rate to decide whether or not they want to proceed with an investment property. It may also be used to help investors sell a property. Cap rate is most useful for rental properties but may not work in all other situations. Cap rate should not be used to evaluate raw land, fix-and-flip properties, or a short-term rental property. The cap rate formula is based on an annual net operating income. Landlords and investors can use cap rates to evaluate different property types, including:

 

  • Multifamily Rental Properties
  • Apartment Buildings
  • Single-Family Rental Homes
  • Rentable Townhomes
  • Commercial Real Estate

 

The cap rate is essential as it can indicate the potential yield of investment properties. This formula calculates net operating income relative to the investment's price. This can help investors see the possible profit margin of the deal. According to Investopedia, the cap rate can reveal how long it will take to recoup the initial investment. For example, a property with a cap rate of 4% will take four years for the investment to be recouped. Cap rate is a valuable way for investors to estimate the risk associated with a property.

 

How to Calculate the Cap Rate: Formula for Capitalization Rate

 

Capitalization Rate = (Net Operating Income/Current Market Value) X 100

 

Cap rates are important, but they're not as challenging to calculate as you might think. Cap rate calculation is easy if you have basic math skills and a cap rate calculator. However, two things are necessary before you can calculate your cap rates:

 

  • The property's net operating income (NOI)
  • The cost of the property

 

It is important to note that calculating a property's value depends on accurate information. Therefore, you will need to do your research and ensure that you have the correct information. You can estimate the annual rental revenue using rental income and subtracting the total operating costs. This article will provide more details on accurately calculating net operating income.

 

Cap Rate vs. ROI

 

The critical difference between ROI and cap rate is the purpose of these metrics. They measure an investor's return on investment (ROI). It's easy to see why entrepreneurs often confuse them. These metrics tell investors what to expect when they invest. However, cap rate and ROI serve different purposes when analyzing a deal.

 

Investors are given an objective percentage of the return on their investment. For example, ROI is expressed as a percentage that estimates the potential return of investors' real estate investments. Investors can then compare the ROIs for entirely different assets. It is also easier to compare assets if they are different. For example, investors can compare the ROI of a 3-month rehab to a 30-year buy and hold.

Cap rates are used to compare real estate assets. A cap rate, for example, would allow someone to compare the returns of two rental properties but is not ideal for investors who wish to compare a rental property with a rehab.

 

Example of Cap Rate

 

The property's net operating income (NOI) is a good starting point for calculating the cap rate. To calculate the NOI, subtract any expenses related to the property (except mortgage interest, depreciation, and amortization) from the property's income. Let's look at a simple example to illustrate this.

 

Let's say you buy a property worth $1,000,000, and it generates $100,000 in rent and has total expenses of $30,000. Your NOI would then be $70,000 (100,000-$30,000). Divide the NOI of $70,000 with the $1,000,000 purchase price to calculate the cap rate. This will give you a 7% cap rate. The following formula can be used to calculate the cap rate:

 

Purchase Price: $1,000,000

Property Income: $100,000

Property Expenses: $30,000

 

NOI: $100,000 - $30,000 = $70,000

Cap Rate: $1,000,000/$70,000 = 0.07

 

0.07 X 100 = 7.7%

 

Can the Cap Rate be Changed?

 

As long as investors know how to increase the NOI, the cap rate can change. This is also known as compressing cap rate. This involves buying a property below market value and renovating it to increase the overall NOI (typically by increasing rental income). If the market is right, renovations can increase the property's value. You could sell the property or keep it, as it would have a lower cap rate. As an investor, you have great control over the property's performance. You can increase your portfolio and change the cap rate with proper planning.

 

The Cap Rate Model

 

Another form of cap rate you should know is the Gordon Growth Model. Also known as the dividend discount model. It calculates the intrinsic value of a stock price. This is how the formula looks:

 

(Required Return Rate - Expected Rate of Growth) = Expected cash Flow / Asset Value

 

The expected cash flow is equal to the NOI. Asset value represents the property's current market price. The cap rate represents the difference between the predicted growth rate and the rate of return.

 

Summary

 

Although it may seem simple, an investment property cap rate has significant implications. Therefore, it is essential to learn more about real estate and ask, "What is a good cap rate?" The best tools for real estate investing, such as cap rates, will give you a better chance of success in real estate.

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