The Capitalization Rate or "Cap Rate" is a quick-and-dirty way to check the financial outlook of a real-estate investment property. You probably wouldn't use it on your primary residence — there are much better ways of making that type of decision.
In fact, cap rate is a relatively volatile statistic when looking at any single-family or single-unit property. So when it does come in handy? Cap rate is often a useful tool when choosing a multi-unit property like a duplex, multifamily building, or a condo development which are all investments of similar risk levels.
Of course, you don't have to be a billion-dollar real estate investor to get a lot of useful, actionable information out of these rates.
Keep reading for further information and frequently asked questions about the Cap Rate.
What Is Cap Rate?
The definition of capitalization rate is basically income divided by value. More specifically, you take the estimated net income the property makes in a year and divide it by the market value, or by a recent purchase price. You'll have to consider your financing costs as well if you're buying on loan.
You typically determine market value by looking at comparable properties. You estimate net income by subtracting the costs of carrying your investment from the revenue you expect to earn.
For example, imagine you were looking at a property valued at $1 million. You estimated you would pay $20,000 in insurance, taxes, management fees and maintenance, and that your tenants would generate $120,000 in revenue over the year. That gives you a cool hundred grand in net income. Divide that by 1 million, and you have a cap rate of 10 percent.
What Is a Good Rate for Rental Property?
What's a good cap rate? Of course, there's no easy answer. You will almost always want to consider cap rate in the context of risk, based on an analysis of the property in question. Generally, most investors aim somewhere between 4 and 12 percent.
If you're a daredevil, it's more likely that you're looking for a moderate-risk property with a high rate. If you're anti-risk, then you'll probably focus on high-value, low-risk and lower-rate properties.
Is Cap Rate Accurate?
Capitalization rates are not the be-all and end-all of the decision-making process, mostly because of the risks involved. These depend on the property in question, but the big two risks that throw off cap-rate projections are lower rates of occupancy and higher costs of maintenance than expected.
Remember that million-dollar property? You'd be looking at a cap rate of 2.5 points versus your estimated 10 if it sat vacant half the year. You would lose half of your projected revenue, but your cap rate would fall by 75 percent. The reason: Your annual cost of carry remained the same, so it cut further into your revenue on a percentage basis.
This level of vacancy is typically much more of a risk in a single home than a multifamily property, so plan accordingly. As a smaller investor — one who isn't buying condo towers with hundreds of units, that is — you may want to use more conservative methods, such as holding out for higher rates when entering riskier situations. For more questions on cap rate and other investment stats, feel free to contact our agents directly.