What is Cap Rate? A Look at Important Investor Formulas and ROI Metrics
A capitalization rate (also known as cap rate), according to Investopedia, is “used in the world of commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property. This measure is computed based on the net income which the property is expected to generate. It is calculated by dividing net operating income by property asset value and is expressed as a percentage. It is used to estimate the investor's potential return on their investment in the real estate market.”
A cap rate is widely used for comparing the value of similar rental property investments in the market. However, it should not be the only indicator of the strength of the investment because it doesn’t account for leverage, future cash flows, or the time value of money. Cap rates mostly depend on the context of the market and the rental property, so there aren’t precise ranges for good or bad cap rates.
In general, a cap rate will look at a one year rate of return for a rental property, whereas a Return on Investment (ROI) can only be used for assets that produce income. Cap rate will typically give a better picture of the rental property and comparable homes in the area. Cap rates are subject to high variance since they are based on the projected estimates of future income, and give a timeframe for how long it will take to recover the amount you’ve invested in a rental property.
The different formulas used to calculate cap rate are:
Net Operating Income / Current Market Value = Cap Rate
This is the most commonly used model for calculating the cap rate. In this model, the net operating income represents the expected annual income from the rental property after deducting all expenses from managing the property (including regular upkeep costs and property taxes). The current market value is the present-day value of the rental property according to market rates.
Net Operating Income / Purchase Price = Cap Rate
The second model isn’t as popular as the first for two reasons. It provides unrealistic results for properties that were purchased at low prices years/decades ago, and it can’t be applied to inherited properties since the purchase price is zero. Since rental property prices widely fluctuate, the first model uses the current market price - giving you a more accurate representation - whereas, the second model uses the original purchase price.
Whichever formula you use to calculate cap rates and ROI metrics, it’s important to be consistent so you can maintain data integrity, and that the metrics should always be used in addition to other data, not limiting them to one perspective.
When you’re looking at the cap rate for a rental property, or you’ve created one and want to connect with real estate investors, Renovo’s Circle of SuccessTM can help. Contact us today to see how Renovo can help you realize the potential of a rental property you’re looking to purchase.