What's a Cap Rate?
In short, a capitalization rate (cap rate) is the expected rate of return on an investment property.
How is it calculated?
Capitalization Rate = Net Operating Income / Current Market Value
The cap rate can be helpful when quickly comparing the value of similar real estate investments in the same market. However, as is true with all investment calculations (see previous blogs about the 1% rule and GRM), it shouldn’t be the only calculation used.
The cap rate value will be higher for properties that generate higher net operating income and have a lower valuation.
When calculating the property’s net operating income be sure to include expenses like property taxes, insurance, repairs and legal costs. Less obvious, but also important, are potential vacancies as part of your equation. Most investors assume an average of 10% vacancy, but do research in the area you plan on investing in. Or let us pair you up with an agent that’s an expert in the market you’re looking in.
Let’s take an example of two properties: one in Beverly Hills and one in Portland, Oregon.
All things being equal, the Beverly Hills property will generate a higher monthly rental earning compared to the property in Portland. But, those will be offset by higher maintenance costs and higher taxes. Beverly Hills will have a lower cap rate compared to Portland because of its higher market value.
what’s a good cap rate?
There’s no single value that makes for a “good” cap rate as it’s dependent on the investor’s strategy. Generally, a high cap rate will indicate a higher level of risk and a lower cap rate will indicate lower returns and a lower risk.