What Is Cap Rate? ... and Should You Care About It?

By
Real Estate Agent with Coldwell Banker Realty NRDS # 146013739

Rojo Vista VOC Sedona

Two Main Things An Investor Wants to Know...

1. Is there a rental history on the property?

2. What is the cap rate of the property?

Key Point: If you are dealing with investors, they will understand what "Cap Rate" is, so it is essential that you understand the term.

questions question questions

What is Capitalization Rate or "Cap Rate"?

The cap rate is a term that can confuse most people. Different calculations can be used to determine the cap rate and income expectations. It is my opinion that if you are buying real estate for investment purposes, you should make sure you compare "apples to apples"!  You don't need to concern yourself with the cap rate if you do not use this property for income.

So What's the Bottom Line?

The simple explanation for Cap Rate is Net Operating Income  (NOI) divided by the Property Asset Value or Market Value - (NOI / Property Asset Value). Because rental properties are usually very different, it can be challenging to determine the fair market value of a property. A property with lower expenses and higher rental potential will command more on the market than one with higher expenses and lower rents.  

When buying a home, this is a very personal choice, not so much when buying an investment property. Cap Rate helps to determine what the value of the property is to you. In other words, what type of annual return do you want to get?

Sounds simple enough, right? - Not So Fast!

Where you can get into the weeds is when you start comparing properties. If you do not do the assessment of the cap rate yourself, find a person you trust who can compare and vet the data and will do it the same way on every investment opportunity. (Apples to Apples!)

Tip: You might want to use a form or "cheat sheet" with all the income and expense variables listed so you do not miss any categories.  Homes or duplexes will be much easier to calculate than dealing with commercial properties or apartment buildings.  With commercial real estate, there may be added costs or expenses such as Management company, marketing, permit fees, taxes, and other costs that you may not be aware of in the local area. Having a professional help specify the finer points of a possible purchase is always a good idea.

Homes Profit and Loss ROI

Rental History vs. NO Rental History

If you have a rental history and expense history, the cap rate will be more accurate than any estimate.  You also need to figure out the vacancy rate for your area.  Here is an example. In West Sedona, finding a home to rent is sometimes very difficult. This would indicate that the vacancy rate may be below the national average of 6.4%.  It is essential to figure out the vacancy rate. A reliable property management and rental company can give you that information.  In Sedona and the Verde Valley, I can help with that information. Contact Sheri Sperry.  

Also, if you have a property where you will need a property manager and are considering a tenant as the property manager, any discount in rent should be included in your operating expense. Check with your financial advisor to determine the appropriate expense. After all, you would have to hire a property manager.

Here are some of the rental property expenses that investors must consider.

~ Property Management ~ Property Improvements ~ Property Taxes ~ Homeowners Insurance ~ Utilities ~ Tenant Screening ~ Marketing ~ Accounting Fees ~ Business Permits ~ Vacancy Costs - HOA Costs ~ Maintenance ~ Mortgage ~

~ Plus, all the costs associated with buying and selling a property ~

Download this simple spreadsheet for rental property analysis

Spreadsheet Courtesy of Roofstock

What Is An Acceptable Cap Rate?

There is no simple answer in this quest to find the right property. Only you can determine what may be acceptable. Other considerations are the area the property is located in and what is the long-term appreciation you can expect.

Basically, the cap rate helps you determine what kind of annual return you will get on the money you invest in the property.  It can also determine what you should pay for the property. The formulas below will assist you.

Some commercial real estate professionals feel that a return of less than 5% could put your investment at risk and require infusing more money into the property if something happens that is unexpected.  Better yet, a 7% to 9% Cap Rate is less risky and is preferred by investors.

Some refer to infusing money into the property as a capital call. This is especially true when other investors are involved, such as in a partnership or corporation like an LLC (Limited Liability Corporation).

It may involve a substantial repair, remodel or build-out for a tenant. The money must be funded using a capital call if very little is in reserve. The higher the return, the more value the property holds. This also helps to keep more in reserve to minimize the risk of a capital call.  

  • Net Operating Income (NOI) = Annual Rent minus Annual Expense.

 

  • Cap Rate = NOI divided by Market Value or Property Assessed Value.

 

  • Property Assessed Value = Annual Income divided by Cap Rate.

 

Home Expense Profit and Loss

Note: Vacancy rate will periodically change. Check your area to see the current vacancy rate.

Four Reasons To Own Rental Property

  • Property Appreciation
    • In today's market, think long-term. Five years minimum.  Even better, 7 to 10 years.  NAR estimates a 6.74% appreciation annualized over the last 50 years.
  • Mortgage Reduction
    • If you purchase wisely, your tenant is paying your mortgage payment.  Consider the rental income average for the area the property is located in. 
  • Tax Benefits and Deductions
    • Besides depreciation and deducting mortgage interest, there are deductions for travel, HOA fees, repairs, home office, cell phone, maintenance, etc... This adds up quickly. 
  • Cash Flow
    • If you analyze the property correctly, there will be cash flow. 

Each of these items contributes to the ROI.  Of course, there are risks involved. But a solid analysis will help to minimize the risks. Always involve your tax or property advisor to help you with your analysis.

 

 


10 Reasons Why Sheri Is Your Solution

Please contact me to discuss how I can help you with all of your real estate needs. I want to help you navigate through the process. I love helping people buy and sell homes – it’s my expertise and what I do!  

Western Hills homes in Sedona call Sheri Sperry for all your real estate needs 928.274.7355

 

Comments (29)

Sheri Sperry - MCNE®
Coldwell Banker Realty - Sedona, AZ
(928) 274-7355 ~ YOUR Solutions REALTOR®

Hi John Pusa,

Thank you.  I have invested in some commercial real estate and I remember how the conversations with other investors revolved around cap rate.

Jun 09, 2023 01:56 PM
Sheri Sperry - MCNE®
Coldwell Banker Realty - Sedona, AZ
(928) 274-7355 ~ YOUR Solutions REALTOR®

Hi Endre Barath, Jr. - Great minds think alike!  Ha Ha!

Jun 09, 2023 01:57 PM
Sheri Sperry - MCNE®
Coldwell Banker Realty - Sedona, AZ
(928) 274-7355 ~ YOUR Solutions REALTOR®

Thank you Charles Ross - (785)-819-6944 for stopping by.  Have a great Friday.

Jun 09, 2023 01:58 PM
Sheri Sperry - MCNE®
Coldwell Banker Realty - Sedona, AZ
(928) 274-7355 ~ YOUR Solutions REALTOR®

Hi Nina Hollander, Broker - This is so true!  Investors have a much different way of analyzing property than residential buyers who plan on living in their home.

Jun 09, 2023 02:04 PM
Sheri Sperry - MCNE®
Coldwell Banker Realty - Sedona, AZ
(928) 274-7355 ~ YOUR Solutions REALTOR®

Hi Brian England - It is always good to revisit these topics, unless you deal with investors on a regular basis.

Jun 09, 2023 02:06 PM
Sheri Sperry - MCNE®
Coldwell Banker Realty - Sedona, AZ
(928) 274-7355 ~ YOUR Solutions REALTOR®

Hi Lawrence "Larry" & Sheila Agranoff. Cell: 631-805-4400 - Thank you. I have watched eyes gloss over when discussing this topic.  It is easier to see in a blog format.

Jun 09, 2023 02:13 PM
Sheri Sperry - MCNE®
Coldwell Banker Realty - Sedona, AZ
(928) 274-7355 ~ YOUR Solutions REALTOR®

Thanks for stopping by Will Hamm.  Have a great weekend.

Jun 09, 2023 02:13 PM
Sheri Sperry - MCNE®
Coldwell Banker Realty - Sedona, AZ
(928) 274-7355 ~ YOUR Solutions REALTOR®

Hi Joan Cox - You really do need a cheat sheet.  Experienced investors are very savvy.

Jun 09, 2023 02:40 PM
Jeff Dowler, CRS
eXp Realty of California, Inc. - Carlsbad, CA
The Southern California Relocation Dude

Sheri:

Well done explanation of Cap Rate and why it is so important, or should be, for investors when considering an investment property. It's a key analysis for investors to do for their decision making.

Jeff

Jun 09, 2023 07:44 PM
Endre Barath, Jr.
Berkshire Hathaway HomeServices California Properties - Beverly Hills, CA
Realtor - Los Angeles Home Sales 310.486.1002

Sheri, loved the bantering with you and Brian England  now with that said it is important to put this information out... sadly there are many agents who do not know or understand it and that is a shame because if the buyer understands it .... we should be more knowledgeable than the clients, Endre

Jun 09, 2023 11:17 PM
Wayne Martin
Wayne M Martin - Chicago, IL
Real Estate Broker - Retired

Good morning Sheri. Excellent post about cap rates. As a former asset manager of a large group of properties, I can say that not only do you have to understand "cap rates" and the calculation, you have to understand the numbers. Some are accurate and some are not. You only get out what you put in. Enjoy your day.

Jun 10, 2023 06:21 AM
Leanne Smith
Dirt Road Real Estate - Golden Valley, AZ
The Grit and Gratitude Agent

As someone whose investors are mainly vacant land and not residential properties, I do not need to know about CAP rate. However, once in a while I do have a residential investment client and undertook some time to understand CAP rate. Your information was very well presented. Thank you.

Jun 10, 2023 07:55 AM
Roy Kelley
Retired - Gaithersburg, MD

This is great information to share. I will schedule a reblog.

Have an outstanding weekend.

 

Jun 10, 2023 08:34 AM
Michael J. Perry
KW Elite - Lancaster, PA
Lancaster, PA Relo Specialist

Many Agents are Lopsided with Cap Rate and tell their  clients to make their buying decisions by using it . These agents totally ignore the FOUR Annual Benefits of Rental Real Estate ( which could easily exceed 20+% !!!

Jun 10, 2023 12:44 PM
Sheri Sperry - MCNE®
Coldwell Banker Realty - Sedona, AZ
(928) 274-7355 ~ YOUR Solutions REALTOR®

Hi Jeff,

This is such an important issue for investors.  But agents do need to have a working understanding of the concept.

Jun 14, 2023 11:49 AM
Sheri Sperry - MCNE®
Coldwell Banker Realty - Sedona, AZ
(928) 274-7355 ~ YOUR Solutions REALTOR®

Hi Endre Barath, Jr. - Excellent point!  It it like buying a car, if a buyer knows more than the salesperson,  they would probably not have much confidence in any answer to a question they might have.

Jun 14, 2023 11:51 AM
Sheri Sperry - MCNE®
Coldwell Banker Realty - Sedona, AZ
(928) 274-7355 ~ YOUR Solutions REALTOR®

Hi Wayne Martin - You are so right.  Which brings up the point that we as agents and brokers need to understand those facts.

Jun 14, 2023 11:53 AM
Sheri Sperry - MCNE®
Coldwell Banker Realty - Sedona, AZ
(928) 274-7355 ~ YOUR Solutions REALTOR®

Thank you Leanne Smith - This info is a good refresher to keep us sharp with investors.

Jun 14, 2023 11:54 AM
Sheri Sperry - MCNE®
Coldwell Banker Realty - Sedona, AZ
(928) 274-7355 ~ YOUR Solutions REALTOR®

Thank you Roy for the reblog!

Jun 14, 2023 11:55 AM
Sheri Sperry - MCNE®
Coldwell Banker Realty - Sedona, AZ
(928) 274-7355 ~ YOUR Solutions REALTOR®

Hi Michael J. Perry - thank you for adding your perspective.  There is more to investment buying as you note.

Jun 14, 2023 11:56 AM