Understanding Capitalization Rate (Cap Rate)
The Capitalization Rate, or "Cap Rate," is widely regarded as the most important metric in commercial and investment real estate. It acts as a thermometer for a property's value, telling you the relationship between the income the property generates and its purchase price. Essentially, it helps you answer the question: "If I bought this property with all cash, what percentage return would I make in the first year?"
Cap Rate = (Net Operating Income / Purchase Price) × 100
How Cap Rate Works
Cap rate and property value have an inverse relationship. As the cap rate goes down, the property value goes up (because investors are willing to pay more for the same stream of income). Conversely, as the cap rate goes up, the value goes down (investors demand a lower price to achieve the higher return).
- Example A: A building produces $100,000 in NOI. At a 5% cap rate, it is worth $2,000,000.
- Example B: The same building producing $100,000 in NOI. At a 10% cap rate, it is worth only $1,000,000.
Calculating Net Operating Income (NOI)
To use this calculator accurately, you must input the correct Net Operating Income. NOI is calculated by subtracting all operating expenses from the total income.
What to Include: Property taxes, insurance, management fees, maintenance/repairs, utilities, landscaping, and vacancy reserves.
What to Exclude: Mortgage payments (principal and interest), capital expenditures (like a new roof, though some investors reserve for this), and depreciation. Cap rate measures the property's performance, not your financing structure.
What is a "Good" Cap Rate?
There is no single "good" cap rate, as it depends entirely on the risk profile of the asset and the market it's located in. However, here are some general guidelines:
Low Cap Rate (3% - 6%)
Characteristics: High demand, Class A properties, prime locations (like NYC, Los Angeles, or Austin), low vacancy risk, high appreciation potential.
Investor Profile: Investors looking for safety, stability, and long-term appreciation rather than immediate cash flow.
Mid Cap Rate (6% - 8%)
Characteristics: Stabilized assets in growing secondary markets, Class B properties, or suburban locations with solid fundamentals.
Investor Profile: Balanced investors looking for a mix of monthly cash flow and moderate appreciation.
High Cap Rate (8% - 12%+)
Characteristics: Distressed properties, Class C/D neighborhoods, rural areas, or properties with high tenant turnover risk. May require significant renovation.
Investor Profile: Aggressive investors seeking high monthly cash flow who are willing to take on more management headaches and risk.
When to Use Cap Rate
Cap rate is most useful when comparing similar properties in the same market. If three apartment buildings in the same neighborhood are selling for different prices, calculating the cap rate for each will effectively "level the playing field" and show you which one offers the best income relative to its price.
However, avoid using Cap Rate for single-family home flips or properties with no income history. In those cases, other metrics like Cash-on-Cash Return or After Repair Value (ARV) are more appropriate.
