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I often preach that it’s essential always to know your numbers when it comes to a deal. Seasoned inventors have numerous tools in their toolbox to analyze various properties. Having the cap rate calculator is no exception!
However, a tool means nothing unless you can understand how to use it properly. Just because I own a wrench doesn’t necessarily mean I’ll successfully stop a dripping kitchen sink! (For the record, the dripping stopped, but the water pressure is now low.)
I’ll break down what is a cap rate and help you determine when you should use it. Also, I included the easiest cap rate calculator. So, when you’re in need, it’ll be right here for you!
What is Cap Rate?
Cap rate (short for capitalization rate) definition is the ratio of the annual net operating income (NOI) to the purchase price of an investment property, usually a commercial real estate (CRE) property.
It’s a quick way to help investors determine an investor’s potential return they will receive and if it is comparable to the other properties in the area. Investors commonly compare it to gaining interest on your investment.
However, the real estate cap rate is not the same as the return on investment (ROI). ROI takes into account financing, specifically mortgage payments and down payment. A cap rate assumes a buyer purchased their property all in cash.
The financing for a commercial property can vary between real estate property types, such as an apartment complex, an office, industrial retail, etc. Therefore, a cap rate needs to be independent of debt service coverage and interest rates.
Why is Cap Rate Important?
When it comes to a residential rental property, investors and lenders use “comps” to determine the current market value of that kind of property. Multiunit properties with less than five units are residential properties. This particular qualification is beneficial to anyone interested in house hacking.
When it comes to commercial properties, cap rates are used as a metric for comparison to determine its current market price. However, like property types, not all cap rates are equal!
The property class type, its location, and its market can directly affect a cap rate’s value. For example, the current cap rate for a real estate business office in downtown San Francisco, CA, cannot be fairly compared to an apartment building in a suburb in Omaha, NE.
Also, the cap rate is a way for investors to measure risk. Although a higher cap rate can provide a good return on one’s real estate investment, it also begs why the cap rate is high.
A cap rate is a function of the property’s net operating income (i.e., cash flow) and the purchase price. Therefore, an older building purchased at a relatively low price may require more maintenance expenses. Also, it might be a telltale sign of poor property management or less creditworthy tenants.
Not all investment strategies are the same. Instead, investors have to weigh the pros and cons and determine what they value more.
How to Calculate Cap Rate?
The cap rate formula is the annual net operating income divided by the purchase price:
Capitalization Rate Formula = Annual Net Operating Income / Purchase Price
The net operating income is calculated by taking the gross rental income and subtracting the operating expenses.
Some operating expenses are property management fees, landscaping, and utilities. Depending on if the tenants signed a triple net lease, property taxes and insurance may also be a part of the expenses.
Net Operating Income = Gross Operating Income – Operating Expense
For example, an apartment complex has 20 units, and each unit pays $700 in rent a month. The gross rental income for the month is $14,000 (20 x $700), which is an annual gross income of $168,000.
The monthly operating cost for the property management, maintenance of the common areas, and utilities is $5,000.
Therefore, the monthly net operating income is $9,000 ($14,000 – $5,000) or $108,000 a year. Furthermore, the purchase price of the apartment complex was $1.8 million. Thus, the cap rate is 6%.
Cap Rate Calculation = Annual Net Operating Income / Purchase Price = $108,000 / $1,800,000 = 6%
Conversely, an investor can arrange the cap rate formula to determine a fair purchase price knowing the annual net operating income and the cap rate.
For another cap rate example, a property with an annual NOI of $20,000 and a cap rate of 5% produces an estimated purchase price of $400,000.
However, according to this example, there are other things to consider besides price to determine if it’s a good deal. For instance, an expiring lease can provide opportunities for a real estate investor to raise rents!
Cap Rate Calculator
Here are two common ways to utilize the capitalization rate calculator:
- Determining the cap rate provided the net operating income and purchase price
- Determining the purchase price provided the net operating income and cap rate.
What are Property Classes and Tiers?
Investors categorize commercial properties into three different classes: Class A, Class B, and Class C. And, alongside property classes are tiers. Usually, properties that are in a higher class or a higher tier tend to have a lower cap rate.
Property classes represent different levels of quality, age, and location determines the property class:
- Class A – Highest quality, highly desirable location, and relatively new. It attracts creditworthy tenants.
- Class B – Medium quality, good location, and decent age. This class is a mix of Class A and Class C.
- Class C – Lowest quality, less desirable location, and in need of significant improvements. It attracts less creditworthy credit tenants.
However, a property can fall in class ranking. This fall in class ranking can be caused by a property that does not keep up with regular maintenance or does not keep up with new construction in the neighborhood.
For example, in my area, there was a shopping mall that had popular department stores, such as JCPenney and Dillards. The shopping mall did not keep up with the surrounding new construction. Those big named tenants moved out and have been replaced with “mom and pop” shops that are called “Pants & Shirts.”
According to Investopedia, tiers refer to the level of development of a city. Below is the description of the Tiers I, II, and III.
- I – Highly developed and large metropolitan areas (i.e., New York, Los Angeles).
- II – An up-and-coming city in the process of developing (i.e., Seattle, Pittsburgh).
- III – An underdeveloped city or a non-existent real estate market (i.e., Akron, Biloxi).
What is a Good Cap Rate?
If you’re looking for an exact number as the answer, I’m sorry. Regardless of the property type, the class, the real estate market (i.e., tier), and location within the market can cause various properties to have different cap rates.
For example, a Class A office building type is different from a Class A multi-family property type. Additionally, an apartment complex in downtown Omaha is weighed differently from an apartment complex in the suburban area of Omaha.
The purchase price of properties in Tier I markets is relatively high. Therefore, commercial properties in Tier I markets tend to have lower cap rates than Tier II and Tier III markets.
According to a U.S. Cap Rate Survey conducted by CBRE between August 12, 2020, and August 26, 2020, the average cap rate for Class A properties is between 4% to 8%.
What Can Affect Cap Rate?
The overall cap rate is a function of gross rental income, operating expenses, and purchase price (or market value). A change in one of these values can quickly increase or decrease a property’s cap rate.
It depends on what the owner is trying to accomplish with the cap rate. Are they trying to get approved for financing, or are they trying to sell their property?
An increase in the market value will decrease the cap rate. An increase in property value is especially easy for Class A properties in Tier I markets. Unfortunately, the cap rate may go down depending on the conditions of the real estate industry.
Increasing the gross rental income will effectively increase the net operating income, increasing the cap rate. Landlords justify rent increases by making improvements to the property.
For example, my parking fee at an apartment complex increased because the owner resurfaced the parking garage and installed LED lights.
Owners might have difficulty increase rents for tenants that have a lease that doesn’t expire until after multiple years. This locked-in lease allows the tenants to avoid any rent increases.
Higher class properties often have more increased quality amenities, and landlords strive to keep the property well maintained. Therefore, a well-kept property can also have a low rate.
However, owners can also increase their cap rate by reducing their operating expenses. For example, a landlord can make paying utilities the responsibility of the tenant.
A property in a location with a high vacancy rate can also reduce a property’s net income. Regardless of the kind of investment properties, residential rental properties, or commercial properties, owners should account for vacancies.
An understanding of the cap rate is essential to successful real estate investing. Even though an investor may not invest in commercial properties, that doesn’t mean they are not familiar with the terminology or formula.
Investors may even use a cap rate as to why they did not choose certain types of properties.
A key thing to remember is that cap rate is not a one size fits all. An appropriate cap rate can vary by type, class, location, tier, etc.
Hence, the cap rate is a quick and easy way for an investor to determine what kind of return they’ll get back from their investment. Also, it can indicate the level of risk associated with purchasing the property.
A low cap rate implies a property is low risk and has a high market value, such as 3% to 5%. On the other hand, a high cap rate suggests a higher risk and lower market value, such as 8% to 10%.
Add this cap rate calculator to your real estate analysis toolbox. And, if you’re looking for a rental property calculator, check out the cash on cash return calculator.