One of the greatest advantages of real estate investments lies in their ability to generate ongoing passive income.
And capitalization rates — cap rates for short — let you compare properties’ income potential, compare different real estate markets, and more. You can do all the math on the back of a cocktail napkin, even after your second or third helping.
What Are Cap Rates?
Cap rates might sound jargony, but they’re actually extremely simple.
In short, they simply represent the net return on investment (ROI) you can expect an income property to generate each year, in the form of cash flow. Cap rates don’t include returns from appreciation, and they don’t account for financing, to help you just compare income yields.
Thus, they offer a shorthand way to compare cash flow on different properties if you buy in cash.
Capitalization Rate Formula
You don’t exactly need a degree in mathematics to calculate cap rates. Here’s the formula for capitalization rate:
Cap Rate = Annual Net Operating Income (NOI) ÷ Purchase Price (or Value)
For example, imagine a property nets $8,000 in income per year and it costs $100,000 to purchase. That makes the cap rate 8%. Just remember this is a simplified stand-in for ROI, so don’t mistake it for your actual cash-on-cash return (more on that later).
While the purchase price is easy enough to understand, the annual net operating income requires a little explaining and a formula of its own.
Calculating Net Operating Income
A property’s NOI is simply the net income it generates each year, after operating expenses.
Operating expenses are easy for novice investors and non-landlords to overlook or try to ignore. But the fact is that most rental properties come with expenses that average around half the rent when averaged over time. There’s even a term for it in the world of real estate investing: the 50% rule.
These non-mortgage expenses include:
- Vacancy rate
- Property management costs
- Repairs and maintenance
- Property taxes
- Accounting, bookkeeping, travel, legal costs, and other miscellaneous costs
So when you buy your first rental property, if it rents for $2,000 per month, expect around $1,000 of that to go to non-mortgage expenses. It won’t happen every single month, but you can expect expenses like that averaged out over time.
Oh, and word to the wise: even if you plan to self-manage rather than hiring a property management company, budget for property management fees. It’s still a labor expense, whether you do the labor or you pay a property manager to do it for you. Besides, the day will likely come when you either can’t or no longer want to field 3am phone calls from tenants complaining that a light bulb burned out.
How to Forecast Expenses
Your cap rate figures will only be as good as the expense numbers you plug into the formula.
For each expense figure above, do your due diligence. Call up local landlords, property managers, and real estate agents to find out the vacancy rate in that neighborhood. Look up the local property tax rate, and multiply it by the purchase price. Get quotes for property insurance, and so on.
In other words, get real numbers wherever possible — don’t guess.
With repairs and maintenance costs, I usually estimate around 13% of the rent. But depending on the age and condition of the property, expect them to average out to 10% to 15% of the rent over time.
How Do Real Estate Investors Use Cap Rates?
Cap rates come in handy in several ways as a real estate investor. While some investors use this metric for other purposes, keep the following three main uses in mind as you explore single-family or multifamily real estate investments.
1. To Compare Properties
Imagine two identical properties down the street from one another. They both cater to the same quality of tenant, and both are in the same condition. Which should you buy?
In theory, you should buy the one with the higher cap rate because it will deliver a higher rate of return.
Cap rates offer a quick and dirty way to compare rental income returns on investment properties. They offer a shorthand for a property’s income yield to help you compare properties.
While the example above is uncommon, consider a more common one. After looking around town, you come up with several properties that look promising. One of them offers a cap rate of 8%, another offers a cap rate of 10%. The property with the higher cap rate sits in a lower-end neighborhood, with more crime and higher turnover rates.
Which one you buy depends on your risk tolerance, and your tolerance for landlording headaches. You may well opt for the property with the lower cap rate to avoid the higher risk of break-ins, more frequent turnovers, more difficult tenants, and so forth. Knowing the cap rates of both options helps you compare the properties and decide whether the higher return is worth the risks.
2. To Find Attractive Markets
I actually find the best use of cap rates to be identifying higher-profit housing markets for investors.
For example, as much as tenants and housing activists love to complain about the rents in San Francisco, the ratio of rents to home prices there actually favors tenants — by a lot. So much so that rental investors can expect negative cash flow if they finance a typical rental property there.
In Memphis, however, investors get far more rent for each dollar of purchase price. The ratio of rents to home values favors landlords, leading to high cap rates. It also doesn’t hurt that median home prices in Memphis are a tiny fraction of those in San Francisco, making it easier to invest there.
By researching cities with higher cap rates, you can find markets with high rents relative to asset values. And in doing so you can identify some of the best cities for real estate investors that the nation has to offer.
3. To Set an Offer Price Limit
Often real estate investors set a floor for the minimum cap rate they’ll accept for a property. That in turn helps them set a ceiling for the most they’re willing to pay for any given property.
For example, imagine an apartment building generates $18,000 in net income each year. The seller wants $300,000 for it, which would mean a cap rate of 6% ($18,000 ÷ $300,000 = 6%).
Your minimum cap rate is 7% however, so you offer $257,000 as your highest and best offer ($18,000 ÷ $257,000 = 7%). The seller can agree or decline, but either way you know you’ve stayed within the bounds of your investment strategy.
It frees you to ignore what other people think the market value of the property is, and focus on maintaining your own minimum standards for returns.
Limitations of Cap Rates
Despite their uses as a simple way to compare properties and make investment decisions, cap rates come with several limitations.
First, the very thing that keeps them simple and allows them to compare properties on equal footing is what limits their usefulness for you personally. By ignoring financing, you can compare apples to apples among properties — but that tells you nothing about what you can personally expect to earn on your own cash investment.
Your cash-on-cash return is the return you receive on your actual cash invested in the deal. That includes your down payment, closing costs, and any initial repairs and carrying costs before you rent out the property. And don’t assume that mortgages always improve your cash-on-cash return, either. Leverage can turn a mediocre cap rate into negative cash flow each month.
Imagine a property that offers a 7% cap rate if you were to buy it in cash. You buy it for $100,000, and after all expenses, you net $7,000 each year. Now imagine you were to finance $80,000 of that property, and you net $2,600 per year (after the mortgage payments) on your $20,000 cash down payment. That would put your cash-on-cash return at 13% (ignoring closing costs in both cases, for the sake of a simple example).
Cap rates can help you do a quick analysis, but cash-on-cash return is your true bottom line for any given property. Make sure you calculate the net annual income you can expect on your total cash invested.
Finally, remember that financing terms and opportunities can vary from one location to the next.
You might be able to borrow money at 4.5% interest from a lender in one state, but 6% interest in another where regulations are tighter and fewer lenders operate. Or in high-regulation states, lenders might offer a lower loan-to-value ratio, requiring a 30% down payment instead of 20%. Or lenders could charge higher loan fees in those states, or transfer taxes and recordation fees could be higher.
Cap rates don’t include borrowing terms or closing costs, but these factors impact your profitability and returns nonetheless.
What Makes a “Good” Cap Rate?
Every investor has a different answer for what they consider a good cap rate. Even so, rental properties come with far more hassles and work than truly passive investments like real estate investment trusts (REITs), so you should demand higher returns on them.
I personally wouldn’t invest in a property with a cap rate under 7% or 8%, and I wouldn’t exactly get excited about those numbers. I can earn higher returns on real estate crowdfunding through platforms like Fundrise, Streitwise, and GroundFloor without the rent defaults, eviction moratoriums, or phone calls from alleged adults who don’t know how to change a light bulb.
Those platforms also require a far lower minimum investment, and let me diversify my funds into commercial properties and real estate assets all across the country.
But because platforms like Roofstock have made it so much easier to buy real estate properties from anywhere, buyers have flooded a once-niche market and driven prices up and returns down. That makes the average cap rate on U.S. properties unappealing to me, so deals have to be exceptional for me to consider them in today’s housing market.
What’s a “good” cap rate? One that beats other real estate investments by enough margin to justify all the headaches that come with being a landlord.
Cap rates offer an easy way to compare potential returns on different investment properties. Consider them a fundamental that every new real estate investor should understand.
But they lack nuance, and should be treated as a high-level valuation tactic, not the basis for your investing decisions.
Use them to find good markets and review comparable properties, or to set price ceilings. But remember that they’re only as useful as the accuracy of the numbers you plug into the cap rate formula. If you underestimate vacancy rates or repair costs, it throws off your cap rate calculations — and your bottom line.
Don’t like the idea of all this research to invest in real estate? Skip the labor and learning curve required to buy rental properties, and invest through real estate crowdfunding platforms instead.