What is Capitalization Rate (Cap Rate)?
The Capitalization Rate, commonly known as Cap Rate, is one of the most fundamental metrics in commercial and residential real estate investing. It helps investors measure the potential return on an investment property independent of financing.
Specifically, the Cap Rate indicates the rate of return that is expected to be generated on a real estate investment property based on the income the property is expected to generate. It essentially answers the question: "If I bought this property with all cash, what percentage of my investment would I earn back in profit each year?"
How to Calculate Cap Rate
The formula for calculating Cap Rate is relatively straightforward, but it requires accurate data regarding the property's income and expenses.
To use this formula, you first need to determine the Net Operating Income (NOI):
- Gross Rental Income: The total income collected from tenants.
- Operating Expenses: Costs required to run the property (taxes, insurance, maintenance, management fees). Note that mortgage payments (debt service) are not included in operating expenses for Cap Rate calculations.
- NOI Formula: Gross Income – Operating Expenses.
Example Calculation
Let's say you are looking at a duplex listed for $500,000.
- The property generates $5,000 per month in rent, or $60,000 annually.
- The annual costs for taxes, insurance, and maintenance total $15,000.
First, calculate the NOI:
$60,000 (Income) – $15,000 (Expenses) = $45,000 (NOI)
Next, divide the NOI by the purchase price:
$45,000 / $500,000 = 0.09
Finally, multiply by 100 to get the percentage:
The Cap Rate is 9.0%.
What is a "Good" Cap Rate?
There is no single "good" Cap Rate, as it varies significantly by location and asset class. However, generally speaking:
- 4% – 5%: Common in high-demand, low-risk areas (like downtown NYC or San Francisco). These properties usually appreciate in value over time.
- 6% – 8%: Often considered a healthy balance between risk and return for many suburban residential investments.
- 10%+: Often found in higher-risk neighborhoods or rural areas where property appreciation is unlikely, so investors demand higher immediate cash flow.
Use the calculator above to quickly analyze potential deals and compare properties in different markets.