What does 7% cap mean in real estate?
The cap rate is an asset's unlevered (no mortgage) return, and a reflection of an asset's relative risk. If the buyer were to purchase the property all cash in the example above, and if the property distributes the same net operating income, the buyer would receive a 7% return on their investment.
It's basically a mathematical formula used to calculate the ROI (Rate of Return) you'd expect to receive from a property you plan to purchase. Calculation Example: If the current market value of a property is $1 million and has an NOI (Net Operating Income) of $70,000, then the cap rate is 7% or 1,000,000 ÷ 70,000 = 7.
The capitalization rate (also known as cap rate) is used in the world of commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property.
If you invested $1,000,000 in a property, with a 6% CAP rate, you would receive $60,000, at year-end. Or if your commercial real estate property is generating $100,000 of net operating income per year and the market's CAP rate is 10%. The value of the property is $1,000,000 (100,000 (property value)/. 10 (CAP rate).
Capitalization rate = Net operating income (NOI) / Value
The cap rate shows an investor the return they can expect from an investment and how long it will take for an asset to pay for itself. With a 5% cap rate, the investor can expect a 5% annual return and that the investment will pay for itself in 20 years.
Calculated by dividing a property's net operating income by its asset value, the cap rate is an assessment of the yield of a property over one year. For example, a property worth $14 million generating $600,000 of NOI would have a cap rate of 4.3%.
The cap rate is defined as the ratio between the net operating income (NOI) produced by an asset and its market value, thus constituting the rate at which the NOI is capitalized to derive the price of the asset.
Comparability: Cap rates provide a way to compare the potential returns of different properties. Because cap rates are based on a property's net operating income and market value, they allow for apples-to-apples comparisons between properties that might otherwise be difficult to compare.
While cap rate compares income to property value, yield compares income to total expenses. Property values won't affect yield like it does cap rates, only what the investor paid for the property. So yield may not fluctuate with property values; however, it will change as income rises and falls.
In real estate, a low (less than 5%) cap rate often reflects a lower risk profile, whereas a higher cap rate (greater than 7%) is often considered a riskier investment. Whether an investor deems a cap rate “good” is a direct reflection of whether or not they think the investment's return matches its perceived risk.
What is a good cap rate for a property?
Average cap rates range from 4% to 10%. Generally, the higher the cap rate, the higher the risk. A cap rate above 7% may be perceived as a riskier investment, whereas a cap rate below 5% may be seen as a safer bet. If a property has a 10% cap rate, you should expect to recover your investment in about 10 years.
Understanding Cap Rates
A cap rate is simply the net operating income (NOI) of a property divided by its purchase price. For example, if the NOI of an apartment complex is $800,000 and the purchase price is $10 million, then the cap rate is $800,000/$10,000,000 which equals 8%.
Investors hoping for deals with a lower purchase price may, therefore, want a high cap rate. Following this logic, a cap rate between four and ten percent may be considered a “good” investment. According to Rasti Nikolic, a financial consultant at Loan Advisor, “in general though, 5% to 10% rate is considered good.
In general, a good ROI on rental properties is between 5-10% which compares to the average investment return from stocks. However, there are plenty of factors that affect ROI. A higher ROI often also comes with higher risks, so it's important to compare the reward with the risks.
The formula for a cap rate is simple: cap rate is the annual NOI divided by the market value of the property. For example, a property worth $10 million generating $500,000 of NOI would have a cap rate of 5%. It's important to note, however, that value and price paid are not necessarily the same thing.
An interest rate cap is a limit on how high an interest rate can rise on variable-rate debt. Interest rate caps can be instituted across all types of variable rate products. However, interest rate caps are commonly used in variable-rate mortgages and specifically adjustable-rate mortgage (ARM) loans.
There is a distinct relationship between cap rates and interest rates. The difference between the two is known as the risk premium, and it represents the incremental compensation a real estate investor will receive for taking the risk of purchasing a real estate asset versus a Treasury.
The average cap rate increased from 6.4% to 7% in H2 2023, with expansion across multiple property types.
Net Operating Income (NOI) divided by Price
Let's take a look at an example. Ivan the Investor acquired a property for $1 million. During the twelve months before the acquisition, the property produced Net Operating Income (NOI) of $65,000. This means the historical cap rate is 6.5% ($65,000 / $1,000,000).
The 2% rule is a rule of thumb that determines how much rental income a property should theoretically be able to generate. Following the 2% rule, an investor can expect to realize a positive cash flow from a rental property if the monthly rent is at least 2% of the purchase price.
What is the cap rate formula?
The cap rate formula divides the net operating income (NOI) that a property generates before debt service (P&I) by the property value or asking price: Cap Rate = NOI / Property Value.
Cap rate and ROI are not the same. The cap rate is the expected return based on the property value, but the ROI is the return on your cash investment, not the market value.
The Capitalization Rate or Cap Rate is a ratio used to estimate the value of income producing properties. Put simply, the cap rate is the net operating income divided by the sales price or value of a property expressed as a percentage.
It's an inverse relationship. A high cap rate is good for the buyer because they get a good return on their money. A low cap rate is good for the seller because they get a higher sales price relative to the NOI of the property. To use some numbers to illustrate the relationship.
Capitalization rates do not account for property acquisition costs like interest and closing costs for a very specific reason. The cost of acquiring a property will vary significantly depending on current interest rates, type of loan, and your particular closing costs.
