Cap Rates in Rental Properties: Everything You Need to Know

When investors are looking to buy property, they have to know how much they’ll make or lose. There is an equation they use to calculate the capitalization rate. This equation quantifies whether the investment they are pursuing is worth it.
A cap rate on its own does not bear much weight because it doesn’t take into account factors such as future cash flows from property investments. But with additional data, a cap rate reduces the risk the investor is exposed to during the acquisition.

A cap rate on its own does not bear much weight because it doesn’t take into account factors such as future cash flows from property investments. But with additional data, a cap rate reduces the risk the investor is exposed to during the acquisition.

How to Calculate Cap Rate on Rental Property

Should you calculate cap rates annually or monthly? Annual calculations are the best, especially if your portfolio has several properties. They help you understand which properties are or aren’t performing on a wider scope.

The cap rate is calculated by dividing a property’s net operating income by the current market value. A property’s net operating income (NOI) is the income it generates after deducting all the expenses from the annual rental income. The property’s current market value is the price you expect to pay for the property when using the cap rate formula.

With those two terms defined, here is the NOI formula:

• Net operating income = Annual rental income – Annual operating expenses

With the NOI calculated, use it to calculate the cap rate. Here is the cap rate formula:

• Capitalization rate = Net operating income / Property’s current market value

What if you want to calculate the current market value? Just change the variables and get this formula:

• Current market value = Net operating income / Cap rate

Do you include mortgage and taxes in cap rate calculations?

Mortgage expenses, interest rates, down payments, or any debt-related expenses are not included. The cap rate calculation focuses on the property and not on the finance type used to obtain the property.

As for taxes, property taxes are included because they remain the same. Income taxes are not included since they vary between situations and owners.

What Is a Good Cap Rate for Rental Property?

Various factors define what the average cap rate for rental property will be.

One example is the property’s location; a 4% cape rate is normal in a high-demand area, but the cap rate can be 10% or higher in an upcoming or rural neighborhood.

Other factors influencing the cap rate are:

• The property’s current rental income
• The future rent forecast (rent pro forma)
• The property’s future appreciation
• The investor’s risk appetite

A good cap rate provides the investor with a reasonable balance between risk and profitability. 4 – 10% is a good cap rate. A low cap rate exposes you to less risk than a higher cap rate.

What Causes Cap Rates to Rise?

When cap rates are rising, the term used is cap rate expansion. Cap rate measures return, and investors know there is a relationship between a property’s return and the risk amount involved to achieve it.

When cap rates rise, the market is telling investors that the risk of purchasing property is high, but could come with better returns.

What happens to cap rates when interest rates rise?

When interest rates rise, cap rates rise too. This shift is caused by increased borrowing costs that cause returns to rise in order to maintain the same profitability level. Property prices then have to fall to achieve higher returns.

Other causes for cap rate expansion, apart from rising interest rates, include:

• High supply: When property supply is high, rental rates fall, and the risk attached to a property increases. The returns, therefore, need to rise to compensate investors for the high risk.
• Macroeconomic factors: A poor economy causes cap rates to rise. Unemployment, job and wage growth, and inflation predict poor economic conditions that increase cap rates.

The above reasons are caused by shifts in the market. The property itself can also cause cap rate expansion in these ways:

• If the property is aged
• If a major tenant’s lease is expiring soon
• If a tenant has recently declared bankruptcy

The type of property can cause the cap rate to rise too. Office and hospitality buildings have a higher cap rate than those on multifamily buildings. Cap rates are also associated with a property’s risk profile. Stabilized property has lower cap rates than property in need of renovation.

What does it mean to stabilize a property?

Stabilized property is a property that has been completely renovated or constructed and has reached an occupancy rate of above 90% of its total units.

Stabilized properties attract investors because there is no risk of delay in construction.

Re-Cap

A good cap rate is influenced by factors such as the property’s current rental income or its future appreciation. Cap rates can rise with rising interest rates, a high supply of property, or a poor economy. These changes are due to market shifts. The condition of the property may also increase the cap rate, especially if the property is under renovation.

Overall, the higher the cap rate, the riskier the investment. If your appetite for risk is not high, go for a property with a low cap rate.

Broadmark Realty Capital specializes in loans that suit commercial real estate investors and developers. We can get you the funds you need with our flexible loan terms and vast experience. Contact us and get your next commercial real estate project on the move.