Good Cap Rate: Definition, Formula & Important Notes

What is a Cap Rate (Capitalization Rate)?

The cap rate is a ratio that allows investors to compare different real estate investment options and markets. To calculate cap rate, you will need to know the total expected gross rent from the property, the taxes, maintenance expenses, insurance, and vacancy rates.

The capitalization rate helps tocompare different real estate investment options or even markets. It is a modified version of the Return on Investment (ROI) formula and helps investors clarify their decisions about which property to invest in. A lower value means that the property is expensive, while a higher one means that a property is coming cheap.  

How to Calculate Cap Rate?

The following formula is used to determine the capitalization rate: 

Figure 1. Cap rate formula

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To get the value of net operating income, you will need to know the expected annual rent you can earn from the property. The maintenance expenses, management expenses, property taxes, insurance, and vacancy allowances are all needed to get an accurate net operating income figure. The current purchase price of the property is also required to come to the market capitalization rate. 

The exact cap rate formula is as follows: 

Cap Rate = Annual Net Operating Income (NOI) / Purchase price

NOI = Gross Rental Income – Vacancy, Taxes, Insurance, Maintenance, Other expenses‍

Subtracting all the charges from the total rent will give you the net operating income from the property.

Dividing this net income by the property price you are getting will give you the capitalization rate. 

For instance, if a property were recently bought for $1,200,000 and had an NOI of $110,000, the rate would be $110,000/$1,200,000, or 9.17%.

Cap Rate Example

Let’s take a cap rate example to see how it is commonly calculated. 

Suppose you want to evaluate the option of a Class A set of offices. The building has a Net Operating Income (NOI) of $1,500,000. The selling price is set at $20,000,000. 

Applying the formula on these values: 1,500,000/20,000,000, we figure cap rate to be 7.5%. 

Interpreting and understanding cap rates is essential. From the example above, can you tell if this is a good capitalization rate? Or should you look for another option? How do we determine what is a good cap rate?

For that, you need to know what the capitalization rate is telling you. It shows the percentage return you will get as an investor on property purchases. In the example above, you will earn 7.5% on your cash investment of $20,000,000. 

What is a Good Cap Rate, and Why is it Important?

Now comes the critical question, what is a good cap rate?  The answer from an investors’ perspective is that a higher rate is good. It implies that the return on your investment is high. A good cap rate can be derived by researching real estate deals in the area you are looking to buy in. You have to find the sales price of similar properties and their estimated net operating incomes to know the best cap rate and the worst rate in the area. 

Figure 2. Office Buildings Cap Rates

A capitalization rate can be good or bad, depending on the specific region the property is located in. Property value in New York will be much different from those of the West. For an investor, this means that for $ 1 Mn, there can be different NOIs possible. Similarly, vacancy rates, maintenance charges, and other expenses can vary. In large cities like New York, people always look for cheap rental locations and lower vacancy rates. But maintenance and insurance rates are also higher. This variation from region to region makes the market cap rate a very subjective tool to use. 

Other buildings and localities can impact the gross cap rate for an area. If a new building is available for investment in a place where other buildings are dingy and outdated, the new building NOI could decline. 

A fundamental rule to remember regarding income capitalization rate is that better areas and buildings trade at lower cap rates. At the same time, worse neighborhoods offer higher rates. Experienced traders usually eye high rates with skepticism until they explore the property themselves. 

While market capitalization rates are a valuable metric for comparing and assessing different investment options, it shouldn’t be used on an individual basis to make a buying decision. The decision for investment is very subjective and can vary according to the investor's risk appetite and earning objectives. 

One drawback with this rate is that the formula doesn’t factor in the cost of financing the property. While it makes the calculation easier, the actual calculation of the transaction does not factor in the mortgage costs, interest rates, and other charges. For investors that rely on debt, this makes the market cap calculation a little ineffective as it doesn't factor in a critical item of their investment decision. 

Final Thoughts

The capitalization rate is a ratio that lets investors compare real estate investment options. If you want to calculate cap rate, you need to know the total expected gross rent from the property, the taxes, maintenance expenses, insurance, and vacancy rates. 

The rate helps to compare different investment options as it allows investors to evaluate their decisions about which property to invest in. Since property value and maintenance expenses vary from region to region, the market cap can hold different meanings for different areas. 

Other buildings and localities can impact the capitalization rate for an area. If a new building is available for investment in a place where other buildings are dingy and outdated, the new building NOI could decline. 

In general, however, a lower rate means that the property has low net operating income, while a higher one means that a property has high net operating income.  

To have the many nuances in interpreting cap rate explained in detail, you can try out the Gainy App. The app offers many in-depth interpretations and guides for assessing market capitalization and finding the ideal cap rates for a region.

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