What Is a Cap Rate in Real Estate?

The capitalization rate — or “cap rate” — of a real estate investment is often referred to as the expected unlevered rate of return. Here, we’ll dive into cap rate basics and explore how cap rates compare with another common metric. 

Why Evaluate the Cap Rate for Real Estate Investments?

The cap rate of an investment property helps you compare properties within and across markets. Real estate investors commonly calculate cap rates when evaluating potential deals. Check out CBRE’s Cap Rate Survey to learn more about cap rate trends across markets. 

You can even use cap rates to compare real estate to other asset classes. For example, you might be able to buy a treasury bond that pays 1% interest, a corporate note offering 3% per year, or a real estate investment property with a cap rate of 5.5%. Here, the real estate’s cap rate of 5.5% is easily judged against other opportunities. 

As a side note, real estate investments offer more than just rental income. For more, check out my article on the various ways rental properties can make you money. 

How Do You Calculate a Property’s Cap Rate? 

The cap rate calculation is pretty simple: 

Here, net operating income is your annual profit (revenue – expenses) from the property. 

• Revenue includes rent plus extra income from things like laundry facilities, tenant utility reimbursement (RUBS), and leasing parking spots to residents. 
• Expenses include items like taxes, insurance, and property management fees. 

The property value is typically the market value of the property, not the actual cost of purchase. 

When net operating income goes up, so does the cap rate. When property values rise, the cap rate falls. 

Cap Rate Examples 

Let’s run through a few examples to make sure we understand. 

Example 1: Duplex

Let’s say you have a duplex worth $200,000. Each side rents for $900 per month, for a total of $1,800 per month — that’s $21,600 per year of revenue. 

Taking into account insurance, taxes, management fees, and repairs, the duplex has $8,000 per year of expenses. 

When you subtract expenses from revenue, you end up with $13,600 per year of net operating income. 

Now, the cap rate formula: Cap Rate = Net Operating Income / Property Value 

When you divide the net operating income ($13,600) by the property value ($200,000), you get a cap rate of 6.8%. Not bad! 

Example 2: Apartment Complex

Now we’ll go big. 

Let’s consider a 50-unit apartment complex worth $3.5 million. Each unit rents for $800 per month, for a total of $40,000 per month — that’s $480,000 per year of rental revenue. 

However, you also make $5,000 per year from laundry facilities and $20,000 per year by leasing parking spots to residents. Therefore, your total revenue is $505,000. 

You have a few more expenses with an apartment building. In addition to taxes, insurance, and maintenance, you also pay an on-site staff, a marketing service, and a landscaper. In total, your annual expenses are $300,000. 

When you subtract expenses from revenue, you end up with $205,000 per year of net operating income. 

When you divide the net operating income ($205,000) by the property value ($3.5 million), you get a cap rate of ~5.9%. 

How Does the Cap Rate Compare With Cash-on-Cash Return?

Throughout this article, we’ve discussed unlevered investments. Leverage is a fancy word for debt. When calculating cap rates, we assume that the property is bought with cash, making the investment unlevered. 

In practice, real estate is often bought using debt financing. In these cases, the cap rate doesn’t tell the full picture. 

Another metric, cash-on-cash return, is helpful for judging levered investments. To determine cash-on-cash return, you divide the total cash flow (after debt service) by the total equity invested. 

We’ll dive further into cash-on-cash return in a future article. The main difference is that cap rates assume no debt — cash-on-cash return is more flexible and is a better metric for judging your return on levered investments. 

Cap Rate Limitations

While calculating cap rates can help compare investments on a large scale, you shouldn’t rely on cap rates to accurately forecast actual unlevered returns.

In the examples above, we ignored items like closing costs, which add to your total investment bill. The cap rate also doesn’t account for capital expenditures, which require up-front cash payments in exchange for an expected future increase in rents.

In short, the cap rate is a simplified metric that is best used to judge market sentiment regarding the valuation of income-producing real estate across and within markets.

To forecast return on investment, it’s better to dive into the details and perform an in-depth analysis that accurately forecasts metrics like cash-on-cash return, equity multiple, and internal rate of return.

Any Questions?

If you have any questions about cap rates, forming a legal entity for your properties, or real estate investing in general, feel free to reach out. I love to talk real estate!