{"id":138215,"date":"2020-10-20T16:42:56","date_gmt":"2020-10-20T22:42:56","guid":{"rendered":"https:\/\/www.biggerpockets.com\/blog\/cap-rates"},"modified":"2022-11-11T12:08:15","modified_gmt":"2022-11-11T19:08:15","slug":"cap-rates","status":"publish","type":"post","link":"https:\/\/www.biggerpockets.com\/blog\/cap-rates","title":{"rendered":"How to Calculate and Identify a Good Cap Rate"},"content":{"rendered":"<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">A property\u2019s <\/span><a href=\"https:\/\/www.biggerpockets.com\/blog\/cap-rate-real-estate\" target=\"_blank\" style=\"color: rgb(0, 0, 255); background-color: transparent;\" rel=\"noopener\">capitalization rate<\/a><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">, or cap rate for short, offers a quick, back-of-the-napkin calculation to approximate its returns. While it\u2019s not the final word on investment property returns, it makes a great starting point.&nbsp;<\/span><\/p>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">Cap rates measure a property\u2019s income relative to its cost. As such, they\u2019re useful for comparing income properties such as rentals or commercial properties for buy-and-hold investors, but don\u2019t apply to fix-and-flip investments.&nbsp;<\/span><\/p>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">What are cap rates\u2019 strengths and limitations, and what calculations should you use in conjunction with cap rates? How do you find a market\u2019s cap rate, and how do you predict which way it will move?&nbsp;<\/span><\/p>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">If you invest in income properties, make sure you understand cap rates\u2019 uses \u2014 and their limitations.<\/span><\/p>\n<h2><span style=\"color: rgb(47, 84, 150); background-color: transparent;\">How to calculate cap rates<\/span><\/h2>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">The formula for calculating cap rates is simple enough:<\/span><\/p>\n<p class=\"ql-align-center\"><em style=\"color: rgb(0, 0, 0); background-color: transparent;\">Net operating income (NOI) \u00f7 purchase price (or current market value)<\/em><\/p>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">Of course, it immediately raises a follow-up question for beginner investors: How do you calculate net operating income (NOI)? Fortunately, that\u2019s just as simple.<\/span><\/p>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">You calculate NOI by subtracting the following annual expenses from the gross rental revenue:<\/span><\/p>\n<ul>\n<li><span style=\"background-color: transparent;\">Property taxes<\/span><\/li>\n<li><span style=\"background-color: transparent;\">Insurance<\/span><\/li>\n<li><span style=\"background-color: transparent;\">Maintenance and repairs<\/span><\/li>\n<li><span style=\"background-color: transparent;\">Vacancy rate<\/span><\/li>\n<li><span style=\"background-color: transparent;\">Property management fees<\/span><\/li>\n<\/ul>\n<h3><span style=\"color: rgb(31, 56, 99); background-color: transparent;\">Sample cap rate calculation<\/span><\/h3>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">Say you\u2019re considering a property priced at $100,000 that rents for $1,000 per month. It generates a gross income of $12,000 per year, and you subtract out the following expenses:<\/span><\/p>\n<ul>\n<li><span style=\"background-color: transparent;\">Property taxes: $1,500<\/span><\/li>\n<li><span style=\"background-color: transparent;\">Insurance: $800<\/span><\/li>\n<li><span style=\"background-color: transparent;\">Maintenance and repairs: $1,800<\/span><\/li>\n<li><span style=\"background-color: transparent;\">Vacancy rate: $700 (~6%)<\/span><\/li>\n<li><span style=\"background-color: transparent;\">Property management fees: $1,200 (including the occasional new tenant placement)<\/span><\/li>\n<\/ul>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">Those expenses come to $6,000 per year, so when subtracted from your $12,000 gross annual income, that gives you an NOI of $6,000. You then divide that $6,000 NOI by the $100,000 purchase price to reach a 6% cap rate.&nbsp;<\/span><\/p>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">Is that good? Bad? It lies somewhere in the normal or average range\u2014because unfortunately, what makes a \u201cgood\u201d or \u201cbad\u201d cap rate varies dramatically by area. But the real value of cap rates doesn\u2019t necessarily lie in their insights into a single property, but rather as a comparison tool.&nbsp;<\/span><\/p>\n<h2><span style=\"color: rgb(47, 84, 150); background-color: transparent;\">Advantages of cap rates<\/span><\/h2>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">Yes, cap rates offer a useful shorthand estimate of a property\u2019s potential income yield. But other calculations can provide a better analysis of individual property returns, which raises the question of how cap rates actually serve you as a real estate investor.&nbsp;<\/span><\/p>\n<h3><span style=\"color: rgb(31, 56, 99); background-color: transparent;\">Quickly compare similar properties<\/span><\/h3>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">Rental, multifamily, and commercial investors use cap rates as a universal calculation that they can apply to any property, anywhere, to quickly compare potential yields.&nbsp;<\/span><\/p>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">Imagine that two identical properties are available for sale, right next to each other. Both properties are currently in almost equivalent condition and require similar repairs. One offers a cap rate of 6.5%, the other 7%. All else being equal, you should buy the one that offers the higher cap rate, because it offers a higher potential income yield.&nbsp;<\/span><\/p>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">The problem is that in the real world, all else is never equal. One property will be older or in poorer condition, or it may have a slightly better location, or it may appeal to a different typeof tenant. More on that shortly.&nbsp;<\/span><\/p>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">Even so, cap rates serve as a universal yardstick for fast, easy comparison of potential yields.&nbsp;<\/span><\/p>\n<h3><span style=\"color: rgb(31, 56, 99); background-color: transparent;\">Identify potential cities and neighborhoods for investment<\/span><\/h3>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">Cap rates also provide a quick way to identify markets with potentially higher returns.&nbsp;<\/span><\/p>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">An overpriced coastal city might only offer a citywide average cap rate of 2%. Meanwhile, a more affordable but still thriving Midwestern city could see average cap rates of 6%. As a rental investor, that tells me to take a closer look at that Midwestern city and leave the overpriced coastal city to new real estate investors who don\u2019t know any better.&nbsp;<\/span><\/p>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">You can also use cap rates to compare neighborhoods within a city. Some neighborhoods offer better cap rates than others, and surveying the city\u2019s neighborhoods can help you find the sweet spot between risk and return.&nbsp;<\/span><\/p>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">Which raises an important point: higher cap rates generally mean <\/span><a href=\"https:\/\/www.biggerpockets.com\/blog\/low-income-neighborhoods\" target=\"_blank\" style=\"color: rgb(0, 0, 255); background-color: transparent;\" rel=\"noopener\">lower-income neighborhoods<\/a><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">. The higher the average neighborhood income, the lower the risk of rent defaults, turnovers, vacancies, and other variables which can affect your cash flow. So investors are willing to accept lower yields in these more stable, higher-income neighborhoods.&nbsp;<\/span><\/p>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">Your goal as a real estate investor isn\u2019t to find the neighborhood with the highest cap rate in the country. Your goal is to find the best balance of higher yields without higher risk or headaches.&nbsp;<\/span><\/p>\n<h2><span style=\"color: rgb(47, 84, 150); background-color: transparent;\">Limitations of cap rates<\/span><\/h2>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">Cap rates provide an oversimplified perspective of income properties. This simplicity is their greatest strength, but also their limitation.&nbsp;<\/span><\/p>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">Ultimately, too many novice investors overemphasize cap rates while overlooking a more nuanced property analysis.&nbsp;<\/span><\/p>\n<h3><span style=\"color: rgb(31, 56, 99); background-color: transparent;\">Cap rates ignore hidden costs<\/span><\/h3>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">As alluded to above, cap rates fail to capture every expense or headache that landlords and investors face.&nbsp;<\/span><\/p>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">Lower-income neighborhoods tend to offer high cap rates, but finding reliable tenants can be more difficult. These neighborhoods tend to have higher rent default rates and <\/span><a href=\"https:\/\/www.biggerpockets.com\/blog\/tenant-turnover-solution\" target=\"_blank\" style=\"color: rgb(0, 0, 255); background-color: transparent;\" rel=\"noopener\">turnover rates<\/a><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">. Because tenants tend to deal with more financial and social pressures, paying rent on time may not always be their top priority. Plus, high vacancy rates indicating attracting and <\/span><a href=\"https:\/\/www.biggerpockets.com\/blog\/11-ways-boost-tenant-retention-higher-roi\" target=\"_blank\" style=\"color: rgb(0, 0, 255); background-color: transparent;\" rel=\"noopener\">keeping good tenants<\/a><span style=\"color: rgb(0, 0, 0); background-color: transparent;\"> can be a challenge.&nbsp;<\/span><\/p>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">And as experienced rental investors know, turnovers are where all the labor, headaches, and expenses lie for landlords.&nbsp;<\/span><\/p>\n<h3><span style=\"color: rgb(31, 56, 99); background-color: transparent;\">Cap rates ignore financing<\/span><\/h3>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">If you\u2019ve ever bought a car and chosen between an instant rebate and 0% financing, you know that financing can have a huge impact on your costs. And, in real estate investing, on your returns.<\/span><\/p>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">Imagine you could buy one property with a 20% down payment and a 6% interest rate, but your lender won\u2019t touch another property in a worse neighborhood offering higher cap rates. For that neighborhood, you go to a backup lender, and put down 25% and pay 7.5% interest.&nbsp;<\/span><\/p>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">Because you\u2019ll need to put down more money and pay higher interest, your ultimate cash-on-cash return will be negatively affected. In this situation, cap rate may provide a rosier picture than the reality\u2014which is why a high cap rate isn\u2019t always a pro.<\/span><\/p>\n<h2><span style=\"color: rgb(47, 84, 150); background-color: transparent;\">Other calculations investors should use<\/span><\/h2>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">So when it comes time for due diligence on individual properties, what calculations should you use?<\/span><\/p>\n<h3><span style=\"color: rgb(31, 56, 99); background-color: transparent;\">Cash-on-cash return<\/span><\/h3>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">If you plan to buy with financing, what ultimately matters most is your <\/span><a href=\"https:\/\/www.biggerpockets.com\/blog\/cash-on-cash-return\" target=\"_blank\" style=\"color: rgb(0, 0, 255); background-color: transparent;\" rel=\"noopener\">cash-on-cash return<\/a><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">: the return on investment that you see from your own dollars tied up in the deal.&nbsp;<\/span><\/p>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">A property with a slightly higher cap rate can be a worse investment, if you can\u2019t finance it with the same favorable terms as another property with a slightly lower cap rate. Take the time to run the cash-on-cash return calculations for every property you seriously consider and compare the real <\/span><a href=\"https:\/\/www.biggerpockets.com\/rei\/glossary\/return-on-investment-roi\" target=\"_blank\" style=\"color: rgb(0, 0, 255); background-color: transparent;\" rel=\"noopener\">ROI<\/a><span style=\"color: rgb(0, 0, 0); background-color: transparent;\"> you\u2019d earn on your money.&nbsp;<\/span><\/p>\n<h3><span style=\"color: rgb(31, 56, 99); background-color: transparent;\">Monthly cash flow<\/span><\/h3>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">Similarly, calculate the <\/span><a href=\"https:\/\/www.biggerpockets.com\/blog\/visualizing-cash-flow\" target=\"_blank\" style=\"color: rgb(0, 0, 255); background-color: transparent;\" rel=\"noopener\">monthly cash flow<\/a><span style=\"color: rgb(0, 0, 0); background-color: transparent;\"> \u2014 both gross and net \u2014 that you can expect from any given property.&nbsp;<\/span><\/p>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">You may discover that even a property with a decent cap rate just doesn\u2019t generate enough net cash flow to be worth the headaches of buying and managing it. That goes doubly for Class B or Class C rentals!<\/span><\/p>\n<h2><span style=\"color: rgb(47, 84, 150); background-color: transparent;\">How to find a market&#8217;s cap rate<\/span><\/h2>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">The best tool I\u2019ve found for researching market cap rates is <\/span><a href=\"https:\/\/www.mashvisor.com\/\" target=\"_blank\" style=\"color: rgb(0, 0, 255); background-color: transparent;\" rel=\"noopener\">Mashvisor<\/a><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">. They provide data on the city, neighborhood, and zip code levels, to help you identify both promising cities and neighborhoods within them for income investing. I love that Mashvisor lets you calculate both long-term rentals and short-term vacation rentals in any given market to help you decide on the best investing model for any given location.<\/span><\/p>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">For detailed property information, check out the BPInsights <\/span><a href=\"https:\/\/www.biggerpockets.com\/insights\/property-searches\/new\" target=\"_blank\" style=\"color: rgb(17, 85, 204); background-color: transparent;\" rel=\"noopener\">Property Insights<\/a><span style=\"color: rgb(0, 0, 0); background-color: transparent;\"> feature. It provides the median rent, as well as the 25th and 75th percentile, so you can dial in on specific factors that could affect your investment.<\/span><\/p>\n<h2><span style=\"color: rgb(47, 84, 150); background-color: transparent;\">Predicting cap rate movements<\/span><\/h2>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">As a broad rule, you can get a sense for which way cap rates in any given market are moving based on how rent changes compare to price changes.&nbsp;<\/span><\/p>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">When prices rise faster than rents, expect diminishing cap rates. When rents rise faster, cap rates will likely rise.&nbsp;<\/span><\/p>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">Start with <\/span><a href=\"https:\/\/www.zillow.com\/\" target=\"_blank\" style=\"color: rgb(0, 0, 255); background-color: transparent;\" rel=\"noopener\">Zillow<\/a><span style=\"color: rgb(0, 0, 0); background-color: transparent;\"> as a simple way to review a market\u2019s current rent and price movements. Also check out <\/span><a href=\"https:\/\/www.rentometer.com\/\" target=\"_blank\" style=\"color: rgb(0, 0, 255); background-color: transparent;\" rel=\"noopener\">Rentometer<\/a><span style=\"color: rgb(0, 0, 0); background-color: transparent;\"> as another source for rental market data.<\/span><\/p>\n<h2><span style=\"background-color: transparent; color: rgb(0, 0, 0); font-size: 0.875rem;\">A property with a 2% cap rate probably isn\u2019t worth the hassle. A property with a 12% cap rate probably sits in a high-risk, high-turnover area.<\/span><\/h2>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">But don\u2019t necessarily write off properties with particularly high or low cap rates. Instead, think of cap rates as one more tool in your investing toolkit, a way to tell if you\u2019re on the right track.&nbsp;<\/span><\/p>\n<p><span style=\"color: rgb(0, 0, 0); background-color: transparent;\">Create a real estate investing strategy that balances risk and return and use cap rates as a gauge to help you estimate both. Ideally, look to score excellent deals on properties in areas with moderate cap rates, so that your individual property\u2019s cap rate comes out ahead.&nbsp;<\/span><\/p>\n<p><em style=\"color: rgb(0, 0, 0); background-color: transparent;\">What kind of cap rates do you typically aim for? What have your experiences been when you\u2019ve invested at higher or lower cap rates?<\/em><\/p>\n<p><strong style=\"color: rgb(0, 0, 0); background-color: transparent;\">Tell us in the comments below.<\/strong><\/p>\n","protected":false},"excerpt":{"rendered":"<p>A property\u2019s capitalization rate, or cap rate for short, offers a quick, back-of-the-napkin calculation to approximate its returns. While it\u2019s not the final word on investment property returns, it makes a great starting point.<\/p>\n","protected":false},"author":158586,"featured_media":138216,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[4252],"tags":[],"class_list":["post-138215","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-deal-analysis"],"acf":[],"comment_count":0,"_links":{"self":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/138215","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/users\/158586"}],"replies":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/comments?post=138215"}],"version-history":[{"count":0,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/138215\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media\/138216"}],"wp:attachment":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media?parent=138215"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/categories?post=138215"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/tags?post=138215"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}