What is a Cap Rate?
The capitalization rate is an extremely useful tool to judge potential profit, risk, fair purchase price, and more. Cap rates tell the rate of return on a real estate investment property. In other words, it tells you the % of your initial investment that will be returned to you each year. This means that buying an apartment at a 10% cap rate for $100,000 will return 10% of the initial investment back to you each year.
In mathematical terms, the capitalization rate is (cap rate = net operating income / property value). Net operating income includes all revenues minus operating expenses. Revenues typically come exclusively from rent revenue less vacancy, and operating expenses include all ongoing maintenance costs per year.
What are Cap Rates Used For?
Cap Rates are used in the real estate industry to judge the rate of return for real estate investments. Investors use the cap rate, usually in conjunction with other return metrics, to judge the potential profitability of a real estate investment. Cap rates are often used as a “back of the envelope calculation,” or a quick equation done to instantly judge the feasibility of an investment given a few facts. Cap rates are used throughout the real estate industry by buyers, sellers, and investors as a rule-of-thumb for valuing investment opportunities and gauging potential risk.
Cap rates are also useful when evaluating any real estate investment or sale. By determining the cap rate on a property, it’s possible to extrapolate an investment’s fair purchase price. To get this estimate, we manipulate the capitalization rate formula (cap rate = net operating income / property value) to come up with a very general estimate of a properties’ fair price.
What’s a Good Cap Rate?
In real estate, cap rates on investment properties generally fall between 4-12%. Generally, different sectors within real estate investing have differing cap rate ranges. The hotel industry has higher cap rates when compared to the residential market, for example. In theory, higher cap rates indicate that there’s more money to be made, but it comes with proportional risk that you must take on. It’s the same reason why Government Bonds are virtually risk free with a return rate of 3%, while stocks carry more risk with a historical return rate of 10%. Depending on your own personal investment style, you may prefer a higher cap rate with more risk or a lower cap rate with a more secure investment.
Why Use Our Cap Rate Calculator
Our cap rate calculator is a tool that real estate investors can use to determine the rate of return for real estate investments. Our calculator outputs the capitalization rate of potential investment opportunities by inputting factors such as rental income, maintenance expenses, vacancy, and more.