Most investing decisions come down to math. Property evaluation is too complex without it. If you really understand the benefits and limitations of the most common investment equations, you’ll make better decisions, reduce your work load and be able to act quickly.

The best way to look at a cap rate is as a return on the value of a property. A 10% cap rate will give you 10% return on the value of the property over a single year after costs have been deducted.

## How Cap Rates Work

For many investors, cap rates are the magic bullet. It’s the first thing they turn to when making decisions because it takes into account costs and income. While cap rates do give you a lot of information and help you compare properties, they also leave out a lot of information. Let’s get to the math so we can better understand how it works and how to avoid common mistakes.

Cap Rate = Net Operating Income/Value

NOI is the gross yearly income from a property minus the expenses (does not including mortgage payments, income taxes or depreciation).

Gross income:

• Total of all rents and other income the property produces in a year

Costs include:

• Vacancy loss (how much rent will you lose in an average year due to vacancies)
• Routine maintenance (yard work, painting, etc.)
• Property management fees
• Property taxes
• Advertising
• Utilities that you pay for

Related: Investment Face-Off: Rental Property With 6% Cap Rate vs. REIT With 8% Return

### Example

• Property is valued at \$250,000
• Rental income = \$18,000 a year
• Vacancy loss averages 2% for your area = \$18,000*.02 = \$360 a year
• All expected maintenance = \$1,200 a year
• No property manager, advertising or utility bills for this property
• Property taxes = \$3,000 a year
• Cap rate = (\$18,000 – \$360 – \$1,200 – \$3,000)/\$250,000 = 0.054 or 5.4% cap rate

## How to Interpret Your Cap Rate

Cap rates are different everywhere you go. Because value (price) is part of the equation, cap rates are based on supply and demand in your local area. In the U.S. most real estate falls in the 5%-10% range. It is possible to do better, but it usually requires creative thinking.

Cap rates have three important uses.

• The cap rate can help you understand if a property is priced too high or low for an area. All you have to do is compare the cap rate from the property you are looking at to the average cap rate for the area. An above average cap rate for an area can be an indication of problems with the property.
• If you decide you won’t do a deal unless you get a certain cap rate, then you can use it to decide what price to offer.
• If you know the average NOI (cash flow) for this deal is going to be \$30,000 a year and you will only do a deal with a cap rate of 8% or higher, then you should bid \$30,000/.08 = \$375,000 or less.
• If you know what cap rates are common in the area and and you know the asking price, you can get an idea of the Net Operating Expenses assuming cap rates were used to price the property.
• If the average cap rate in the area is 6% and the asking price is \$300,000, then 0.06*\$300,000 = \$18,000 in expenses for the year.

Related: A Definitive Guide to Understanding Cap Rates and Cash-on-Cash Returns

## Cap Rate Limitations

• Cap rates will not help you evaluate appreciation (increase in value) or any changes that take place over time. Cap rates are a snapshot of right now only.
• Cap rates are based on very few inputs. A small error can significantly change the results.
• Cap rates do not take into account loans used to purchase the property. If your interest rate is different for different properties you cannot use it to help you decide which property is better.
• Cap rates are based on guesses as to the costs and income of a property. Try to get the actual rent and cost information from the property owner. Also, check to see if they have lower than average rents or any deferred maintenance that can significantly impact your NOI.
• Equations are only as good as the data you put into them. Make sure you’re inputting consistent average values from the area, not the values you want to see.

## How to Best Use Cap Rates in Analysis

Think of cap rates as a compass. All they can do is point the right direction. They won’t give you any information about what lays ahead. I like to use cap rates to decide if I should spend more time evaluating a property, that’s it. Whatever you do, don’t let a simple division problem decide your future.

Cap rates can also be used to help you decide what type of property you should invest in. If single family is going for 5%, office buildings 6% and apartments 7%, then you should probably focus on apartments.

Just like anything in an open market, as one type of investment gets better, demand grows, prices increase and profitability drops. Cap rates follow the same trend and can change quickly. Keep an eye on them so you always know what’s going on.

Investors: To what extent do you rely on cap rates to make your decisions about properties?

Let me know with a comment!

### About Author

Brett Lee is a licensed Real Estate Broker in Portland Oregon where he helps people achieve a better future so they can do the things that truly make them happy. Brett is also a buy-and-hold investor, property manager and investment advisor.

### 10 Comments

1. Limitation:

Cap rates are not useful for residential (1 – 4 unit) properties as the market values these properties by comparative sales and not by NOI.

• Smart investors still pay attention to NOI on 1-4 unit properties when valuing them, but dumb money investors and non-investors will value them based on comps. This can lead to the best of both worlds if you can purchase at a favorable price based on NOI and eventually sell at a price that makes no economic sense based on market comparables.

2. Great job on actually explaining the Cap Rate and showing the cap rate using an example property/numbers!

• Travis, any idea where Brett got the \$250,000 value in the example?

3. Brett, where are you getting cap rate comps for single family properties? No legal or mgt. expenses? Even a NNN property will have mgt. Why would you make all these needless calculations on ASKING PRICES? You are doing it backwards. It the market cap is 8% then you use that against the NOI of the properties you are looking at.
Also where are you addressing capital expenses? And how do you come to the conclusion that apartments are the best value when in fact the market is saying apartments are riskier?
NOI is revenue minus ONLY operating expenses, that is why it is called NET OPERATING Icome!

4. Fantastic breakdown of cap rates! Thanks!

5. Well written article…The most important determining factor in a property for me is the “hassle factor.” I could truly care less about Cap Rate…I want a property that cash flows with as little involvement from me as possible.

Oh, and what about:
Accounting
Advertising
Bank Charges
Electricity
Gas
HOA
Insurance – Hazard (Normal)
Insurance – Mortgage
Landscape Maintenance
Legal
Maintenance (Handyman)
Manager Salary/Management Fee
Miscellaneous
Permits & Fees
Pest/Termite Control
Phone
Postage/Shipping
Referrals or Commissions
Reserves
Supplies (Maintenance)
Supplies (Office)
Taxes (Property)
Trash Pick Up
Warranties
Water/Sewer

6. You first said property taxes are not an operating expense, and then you subtracted them in your example? Which is correct?

7. My mistake–you said INCOME taxes are not an expense, and I misread it as property taxes. Never mind!

8. Thanks for the article. The one thing I think is very important to emphasize is that NOI does not equal cash flow unless you have ownership free and clear. Otherwise you more than likely have a significant monthly debt service, and this can very quickly sink you. I know it first hand. People see high cap rates and think cash flow. if it is an existing property with 6-8% cash flow an investor/owner is unlikely to sell it unless a large chunk of cash is needed because the likelihood of finding a better performing, low risk investment (if the property has been held and is paid off or has low debt service) is slim in this market. New commercial properties are different in that respect but the downside is the potantial loss of a tenant and litigation about the broken lease. Appreciation is great but you have to wait for that and it is NOT a given. You also have to have reserves for the unexpected like a 20k roof patch or 30k boiler replacement due to delayed maintenance. These are just things to really consider because some people think NOI = cash flow but it does not unless you have NO debt, mortgage or other financing on the property. It is a question of highest and best use of capital taking many factors into consideration and it still boils down to a bet, albeit a safer one than the stock market (in my opionion) and as we saw in 2008 past performance was not an indicator of future performance, even for properties purchased or owner built in the early 2000’s that were valued at completion based upon their construction/acquisition cost without appreciation.