Cap rate: Defined and explained

As an experienced real estate investor, you probably only buy investment properties with a high chance of turning a profit. There are multiple ways to measure a real estate asset’s profitability, including something called the capitalization rate, or cap rate. 

The cap rate is typically used for commercial properties and can help you find a good deal on a property you’re looking to flip or rent. Let’s look at how the cap rate works and when it may or may not be helpful.

Note that Rocket Mortgage doesn't offer commercial real estate loans at this time, but we like to help you understand your options.

What is a cap rate in real estate?

Cap rates are designed to estimate your future profits, which are often called an annual rate of return. This type of measurement calculates the ratio of your net income to the asset’s current value. It tells an investor what percentage of the current asset value they’ll receive as a return each year.  

However, because the cap rate relies on estimates of future income based on rental income and resale when compared to costs, it may not be entirely accurate. Still, it may be a useful tool if you have realistic data to work with. For instance, in situations where you’re not counting on charging above-market rent. 

The cap rate compares your potential earnings against the costs, but it doesn’t include things like mortgage payments or property taxes. Cap rates are typically used to compare potential investments, while metrics like return on investment (ROI) look at the total profit of a specific property. 

Cap rate formula

The cap rate of a property is determined based on its potential revenue and risk level as compared to other properties. Importantly, the cap rate won’t provide a total return on investment. Instead, it will indicate an estimate of how long it will take to recover your initial investment in a property.

Here’s the formula you’ll use to determine a cap rate: 

Net operating income (NOI) / current market value x 100

For example, let’s say you own a commercial property that brings in $20,000 annually in net operating income (NOI). The NOI is the rental income minus any operating costs, like utilities or vacant units that you’re carrying. The property has a market value of $400,000, so here’s how you’ll calculate the cap rate: 

20,000 / 400,000 x 100 = 5% cap rate

This means the property is expected to offer a 5% rate of return on its value each year. 

What’s a good cap rate?

Although it can be tempting to seek out a universally good cap rate, no single cap rate number will be considered “good” for every property. Instead, the cap rate can be used by investors to determine if a property meets their comfort levels.

As a general rule, the formula will determine a higher cap rate for properties with a higher net operating income and lower valuation. On the flip side, properties with a lower net operating income and higher valuation will have a lower cap rate.

Typically, investors view properties with a lower cap rate as less risky but should expect a longer time frame to recoup their initial investment. As an investor, you should take some time to consider what an acceptable cap rate is for properties in your portfolio. With a number in mind, you can quickly pass on properties that don’t meet your risk tolerance.

When the capitalization rate may not be helpful

Cap rates are typically used by real estate investors to compare the risk involved in buying commercial properties. Although you can use cap rates to inform other real estate investment decisions, it may not be as helpful.

For example, if an apartment building you're considering hasn’t historically generated a consistent income because it’s used for short-term vacation rentals, you may not be able to use the cap rate formula to predict the value of the investment. In this case, it may be easier to use a cash flow model to estimate the return.

The cap rate formula also assumes you’re paying cash for the property you're buying. If you’re considering a mortgage to finance your investment, the cap rate won’t be the best metric to use. Don’t forget that there are many tools to help you. You can use other formulas to determine risk levels and the potential returns of an investment rental property.

The bottom line: Cap rates help you assess profitability

The cap rate is an important metric that helps you quickly analyze the potential profitability of a real estate investment. It gives you an idea of how much income a property could generate relative to its value, making it easier to compare multiple opportunities side-by-side. However, it doesn’t account for financing, taxes, or unexpected costs, so it’s most helpful when paired with other metrics.

If you’re exploring ways to leverage home equity or finance a residential property, Rocket Mortgage can help you understand your options. Start your application today to see what you might qualify for. 

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