Back to newsroomCap Rates: Key Calculations and Their Impact on Property Valuation
When determining an asset’s potential, investors will use various analytical strategies to obtain a clear picture of the value. One such metric is the cap rate.
Cap rates — or capitalization rates — help evaluate the profitability and risk of a potential investment. Learn the answer to “What is a good cap rate?” and become familiar with common cap rate formulas to accurately assess the potential value of investment properties.
What Is the Cap Rate?
Cap rates gauge the potential rate of return on a real estate investment based on the property’s net operating income (NOI). Investment firms and individual investors use the metric to evaluate commercial properties and rental homes. It allows investors to estimate potential profitability relative to the property’s value or purchase price.
Cap rates are particularly useful to compare two or more investment opportunities. However, the metric is not the same as return on investment (ROI).
The ROI of a property evaluates overall gains. When calculating ROI, you’ll account for additional factors such as financing costs and repairs. Both tools are essential, but the cap rate is most effective when assessing the intrinsic value of income-generating properties.
Firms such as OpenPath use key metrics like cap rates and ROI to identify high-potential properties and help you build a productive, efficient portfolio. This unique investment approach blends financial goals with your personal values to promote meaningful social impact.
How Do You Calculate the Cap Rate?
When learning how to calculate cap rate, you can use a few different formulas. The two most common include the following:
Formula 1: Net Operating Income (NOI) / Current Market Value
The first formula is:
NOI / Current Market Value = Cap Rate
First, you’ll need to find the NOI by subtracting your operating expenses from your gross rental income. If your property generates $100,000 annually and your operating expenses are $30,000, the calculation will look like this:
Next, you divide the NOI by the market value. Then, you will multiply the result by 100 to convert the number into a percentage. Suppose that the property’s market value is $1,000,000.
This percentage represents the annual return you can expect to generate. However, it ignores financing fees and other external factors.
Formula 2: Net Operating Income (NOI) / Purchase Price
The second approach uses the purchase price instead of the current market value. When using the same NOI of $70,000, simply divide the NOI by the purchase price and then multiply your result by 100 to convert the number into a percentage.
If the purchase price is $950,000, your calculation would look like this:
These variations illustrate the importance of context when evaluating investment opportunities using the cap rate. If you are able to purchase a property below market value and have lower operating expenses, your capitalization rate will be higher.
What Is a Good Cap Rate?
There isn’t a set definition of a “good” cap rate. You’ll need to consider your risk tolerance and investment goals. High cap rates are often associated with riskier investments.
For example, if a property needs significant renovations, you will likely be able to buy it well under market value, which can increase your cap rate. Low cap rate properties are typically in prime locations with long-term leases and high occupancy rates.
Factors That Can Affect the Cap Rate
Capitalization rates don’t exist in a vacuum. They can be influenced by external factors such as the following:
Location
The property’s location will greatly impact capitalization rates and potential ROI. High-demand areas with strong economic and population growth tend to have lower cap rates.
Competition
If a market experiences a lot of investor activity, it can drive up prices. When the market price of an investment property rises too much in proportion to potential rental income, it can cause cap rate compression.
Property Condition
Run-down properties that need a lot of work will have a higher capitalization rate, but they tend to be riskier. Turnkey investment properties carry less risk, but the cap rates are lower.
Economic Factors
Factors such as GDP growth and shifting interest rates can significantly impact a property’s capitalization rate. Rising interest rates may lead to higher cap rates as borrowing becomes more expensive.
Demand and Supply Dynamics
High demand with limited supply drives up prices, and this can cause compression and lower capitalization rates. An oversupply of properties can push cap rates higher but make it difficult to achieve consistent occupancy.
Rent Control Laws
Rent control laws can influence expected returns and capitalization rates. Purchasing a property that’s subject to strict rent controls may offer a lower ROI as well.
Sustainability
Sustainable and impact-based real estate investment strategies can influence cap rates by attracting socially conscious investors and tenants. This may potentially drive demand and stabilize income. However, the initial cost of energy-efficient upgrades and green certifications may diminish your short-term ROI.
Are There Any Limitations of the Cap Rate?
You should consider the capitalization rate of an investment property when evaluating whether it's a good fit for your portfolio. However, cap rates provide only a piece of the puzzle. This metric is less reliable for properties with irregular cash flow. It does not account for property value appreciation, either.
You should also consider metrics such as the internal rate of return (IRR), discounted cash flow (DCF), and ROI of a property. An experienced firm such as OpenPath will provide a comprehensive look at income-producing properties and inform your investment decisions.
Invest with Confidence Using OpenPath
Cap rates are a great tool for evaluating your investments. However, partnering with an experienced firm that considers other data points like IRR, ROI, and DCF is vital to help you cultivate a strong portfolio.
The experts at OpenPath use cap rate and other data-driven metrics to identify investment opportunities that are a good fit for your portfolio. Our approach emphasizes identifying high-potential properties that balance strong financial returns with sustainable, socially driven outcomes. Contact OpenPath to explore investment opportunities.