What Is a Good Cap Rate? How to Judge One
There is no single good cap rate. It depends on the city, the type of property and interest rates, and a higher number usually comes with more risk. What matters is how a property compares with similar ones nearby, and with what it costs you to borrow.
What a cap rate is
The capitalization rate, or cap rate, is a property's net operating income divided by its purchase price, shown as a percent. Net operating income, or NOI, is the rent and other income left after vacancy and running costs such as tax, insurance, management and maintenance. It leaves out the mortgage and income tax.
Because it ignores financing, the cap rate lets you compare properties on what they earn by themselves, however they are bought.
A worked comparison
- Property A costs $300,000 and earns $18,000 a year in NOI. Cap rate: 18,000 ÷ 300,000 = 6.0%.
- Property B costs $400,000 and earns $20,000 a year. Cap rate: 20,000 ÷ 400,000 = 5.0%.
Property A earns more for each dollar spent on it. That does not make it the better buy. It may be in a weaker area, need more upkeep, or have rents that are hard to hold up. The cap rate is a starting point for questions, not an answer.
What affects what is a good cap rate
- Location. Properties in strong, stable areas often sell at lower cap rates, because buyers will accept less income for less risk.
- Property type and condition. Older buildings and ones that need work usually sell at higher cap rates.
- Interest rates. When borrowing costs rise, buyers tend to want higher cap rates to compensate.
- How reliable the numbers are. A cap rate based on guessed rent and expenses is only as good as the guesses.
To judge a cap rate, look at recent sales of similar properties in the same area. The same percentage can be fine in one market and poor in another.
Cap rate versus cash-on-cash return
Cash-on-cash return is the annual cash flow divided by the cash you put in. Unlike the cap rate, it depends on how you finance the purchase. Borrowing can raise your return when the loan costs less than the property earns, and lower it when the loan costs more.
A $100,000 property earns $6,000 a year in NOI, so the cap rate is 6%. Buying with all cash gives a cash-on-cash return of 6%. Now borrow 75 percent on an interest-only loan, putting in $25,000. These are example figures.
- At 7 percent interest, the interest is $5,250. Cash flow is $750, and the cash-on-cash return falls to 3%.
- At 5 percent interest, the interest is $3,750. Cash flow is $2,250, and the cash-on-cash return rises to 9%.
When the loan rate is above the cap rate, borrowing lowers the return on your cash. When it is below, it raises it. That is one reason the cap rate alone can mislead.
What the cap rate does not tell you
- How the property is financed.
- Appreciation or falling values.
- Large one-off costs such as a roof.
- Income tax effects.
- How much of the loan you pay off over time.
Use it to screen properties, then work through the full numbers on the ones you like. Check them with a lender or accountant before you buy. This guide is general information, not financial advice.
Related
Questions
Is a higher cap rate always better?
No. A higher cap rate often reflects higher risk, such as a weaker location, an older building or less reliable rent. It tells you what the property earns for the price, not how safe that income is.
Should I use the asking price or the price I expect to pay?
Use the price you expect to pay. A cap rate calculated on the asking price is only an estimate until a price is agreed.
Does the cap rate include the mortgage?
No. It ignores financing so that properties can be compared on what they earn alone. Cash flow, cash-on-cash return and the debt service coverage ratio bring the loan into the picture.
What is the difference between cap rate and cash-on-cash return?
The cap rate divides income by the purchase price and ignores your loan. Cash-on-cash return divides annual cash flow by the cash you put in, so it changes with how you finance the purchase.