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Cap Rate Real Estate: What Is A Good Rate & Formula?

If you are interested in real estate investing you probably heard the term cap rate real estate. Cap rate in real estate or capitalization rate is a critical metric in evaluating whether a property is a good investment or not. Understand how to calculate real estate cap rates in the context of commercial and residential investment property scenarios.

What is a cap rate in real estate? Our definition

What is cap rate in real estate? The definition of cap rate in commercial real estate is no different than the one for residential real estate; however, it is more commonly used in commercial real estate acquisitions. Cap rate is calculated by taking the property’s net operating income (gross income less operating expenses) and dividing it by the value of the asset (the estimated price the property would sell for if it were listed today). The result is expressed as a percentage, and shows the rate of return that is expected to be generated on the real estate investment.

Real estate capitalization rates are a snapshots in time that represent the projected yield of a property over a one year timeframe. This rate of return, however, is assuming that the property is un-leveraged, i.e. purchased with cash only.

Why should you care about capitalization rates in real estate?

Cap rates are so important in the real estate industry because they serve as a metric in which you can measure an investor’s potential return on their investment. Moreover, it is a way to compare apples to apples in an industry where you are comparing apples to oranges given the vast and variable factors that are considered in determining and comparing the value of a real estate properties.

Looking at real estate vs. stocks, capitalization rate in real estate is also a method in which you are able to compare your real estate investments and stock market investments on an even playing field, as you are looking at projected annual returns.

Understanding cap rate in real estate and how to calculate it

How to calculate real estate cap rate: Understanding cap rates might be easiest when looking at the real estate cap rate formula. We will walk you through practical hypothetical scenarios, so you can test your conceptual understanding of cap rates and walk away an expert!

The cap rate formula for real estate

Capitalization Rate = Annual Net Operating Income / Current Market Value

Net Operating income = Gross Operating Income – Operational Expenses

Current Market Value = purchase price or appraisal value

 

Commercial property cap rate example

How to calculate cap rate for commercial properties: Let’s pretend that you are thinking about purchasing an office building in downtown Miami that is listed for 10 million. Ostensibly, it looks like a great investment; however, there is no way to know for sure without calculating the commercial real estate property capitalization rate.

First you have to determine the gross operating income. A commercial property’s gross income is generated from rent. During the due diligence process you would obtain the rent roll from the current owner. From the rent roll you ascertain, that all tenants are up-to-date on rent, the building is 95% occupied, earning $50,000 a month in rent, and costing $2,000 in potential rental loss. In addition to monthly rent you earn $1,000 in monthly parking fees. Therefore, your total monthly gross income is: $50,000 – $2,000 + $1,000 = $49,000.

Next you need to calculate your total monthly operating expenses. Operating expenses are the expenses that are required to operate the building, and are made up of variable operating expenses (utilities, pest control etc), as well as fixed operating expenses (property tax, insurance, management fees)–all this information you would require to be provided during the due diligence period. In our hypothetical scenario, from the records you obtain you calculate $20,000 in monthly operating expenses. Non-operating expenses like interest, amortization, depreciation and income taxes are traditionally not included within the calculation. Although, you can if you want to.

Now that you know your gross operating income ($49,000) and your operational expenses ($20,000), you can calculate your monthly net operating income: $49,000 – $20,000 = $29,000. Next, we take this monthly operating income and multiply it by 12 to determine your annual net operating income: $348,000

Finally, we are ready to apply the cap rate real estate formula! Taking our annual net operating income and dividing it by the current market value: $348,000 / $10,000,000 = 3.48%

We will get into how to interpret this percentage momentarily.

Residential property cap rate example

How to calculate cap rate for residential properties: Now let’s pretend that you are thinking about purchasing a residential Miami real estate investment property. Let’s say it is a prospective rental property in Coral Gables that is listed for $400,000.

Just as you did, with your prospective commercial real estate property, you need to first calculate your you gross operating income. This is generated through rent, as well, but instead of having multiple tenants, you have one. Whether the previous owner was renting out the property or not, you should still do your own research to decide what the appropriate monthly rent would be for your investment property. You can check comparable properties’ asking rent price on Zillow.com.  Based on your market analysis, you decide that you can easily rent this property out for $2,200 a month.

Next you need to look at your total monthly operating expenses. As a landlord, you plan on passing down the cost for utilities like water and electricity; however, you still are looking at property tax, home owners insurance and any maintenance like pest control. Based on your research, you are projecting $1,200 a month in fixed and variable operational expenses.

Using your gross operating income and total operational expenses, you calculate your monthly net operating income: $2,200 – $1,200 = $1,000. To make this applicable in the real estate capitalization rate formula, you multiple your monthly NOI by 12 to determine an annual NOI of $12,000.

Next step? You guessed it! Let’s plug in your numbers and see if your rate of return: $12,000 / $400,000 = 3%

Are cap rates any different for commercial and residential properties?

The cap rate real estate formula is the same regardless of the sector. It is NOI that can vary: NOI varies depending on property types; however, even two investors evaluating the same property can calculate NOI differently depending on their investment strategy. The only differentiating factor would be the evaluation of the results of the calculation.

What is a good cap rate for real estate?

Before we get into good cap rates vs bad cap rates, you should understand the high variance in cap rates within the industry: anywhere from 3%- 20% can be an acceptable cap rate. For this reason, an average cap rate is somewhat irrelevant, as the factors that determine this calculation are vast and variable: Office buildings vs hotels vs multifamily homes vs residential rental properties–all have very different factors at play.

Generally speaking, higher end properties produce lower cap rates and up-and-coming properties, like value add investments, result in higher cap rates. This is because of the inverse relationship between cap rates and the property value.

Lower cap rates mean less risk (the property is more expensive better maintained) and higher cap rates are higher risk (the property maybe is in bad condition or is in an up-and-coming neighborhood)… so, it’s up to you to decide on the investment type you want.

What is a good cap rate for commercial real estate?

The truth is that it depends. The perception of the cap rate being good or bad is determined by your expected rate of return and how you plan to get there. What is your investment strategy and your risk tolerance? Are you trying to buy a well maintained building and assume the asset to continue the projected high returns? Well then a lower cap rate is good for you. Are you trying to purchase a value add property and renovate it in an up-and-coming neighborhood? Well then a higher cap rate is good for you.

Within the 3%-20% range, there is no cap rate that is better than another because the cap rate is relative to the perceived risk associated with purchasing the property, the investment strategy, the property type and asset class.

Compressing cap rates is when you buy an investment property at a high cap rate (llower property value property), and selling at a lower cap rate (higher property value). This is usually achieved by buying a “diamond in the rough” property below market rent. Once you renovate it, you can raise rents, which increases NOI, and therefore, the value of the commercial property. This is School of Whales investment strategy. Crowdfunding real estate is a great way to dip your toes in commercial real estate without necessarily concerning yourself with the nuances of cap rates.

What is a good cap rate for residential real estate?

The same answer applies for residential real estate. Your best benchmark is your target ROI. If you are looking for 8% annual return, then you will not be satisfied with your 3% cap rate that you calculated for your prospective Coral Gables rental property. Perhaps if you are going for 8% ROI, then you need to shop around in a neighborhood where property values are lower.

Key takeaways

In conclusion, regardless of commercial or residential, cap rates are used by investors to calculate the potential rate of return on their investment. Cap rate calculations can be manipulated based on investment strategy and how a person calculates NOI. Despite the fact there is a large range depending on asset class, property type, tenant base and location, you should use your desired ROI to decide if it is a good cap rate for you.

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