Understanding Cap Rates and How They Are Used

Capitalization Rates (Cap Rates) are used in real estate to help estimate the expected rate of return on an investment property. Broadly, investors will use the Cap rate to compare the value behind real estate investments in the market and to help with price determination when negotiating a purchase.

Outside of purchase decisions, the Cap rate formula can be a killer tool to help investors determine the overall “health” of their property portfolio in the current market. As values and market rents fluctuate rapidly it’s easy for an investment property performance to fall behind the market. Add in new expenses like tax increases or updating costs and investors can quickly end up leaving a lot on the table if they aren’t adjusting to maximize returns.

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The Formula

The formula to determine the Cap rate on a property is relatively simple, so if you hate math – think of it more as math adjacent. First, you’ll need to determine the current market value of your property (call if you’d like me to run a quick and precise market analysis for you).

**Keep in mind, using the price at which you purchased is useless as this measure is meant to be used in real time with current market conditions. **

From there, calculate the annual gross income from rents, then deduct annual expenses. Expenses will NOT include principle and interest payments but DO include taxes, insurance, utilities, property management, maintenance…and so on. This will give you the Net Operating Income or NOI.

The Formula looks like this: Cap Rate = Net Operating Income/Market Value of Property

The Cap rate will convert as a percentage, so when you run the formula, you’ll likely see something to the effect of 0.05123456…which we’d round to 5.1%.

What’s a Good Cap Rate?

As a general rule of thumb, investors making a purchase in the Denver Metro market currently prefer to see a Cap rate of 5.5% or higher, or at least the potential is there with little to no added cost or time (eg. Rents are low and tenants will renew leases or vacate either before or shortly after the property is purchased).

That said, Cap rate trends fluctuate based on market conditions (mortgage interest rates, values, rents…etc.) and are never/should never be used as the end-all-be-all when looking at the value of a real estate investment.

Most recently (2022) it’s not uncommon to see properties selling even with projected Cap rates in the high 4% to low 5% range. Major outliers would likely be in the range below 4% or above 6.5% for our market. As interest rates increase, desired Cap rates will generally keep pace.

There really aren’t any solid published resources for tracking local Cap rate trends so it’s best to spend time researching the market or better yet consult with an expert Realtor who has an awesome blog on the subject. (My number is 303-815-6243)

Ultimately, it comes down to the individual to decide what level of return they’d require as compared to the perceived risk. If the perceived risks are high then the investor might want to offset that risk with a higher return (including but not limited to a higher Cap rate). Or in the case of our market, both values and rents have continued to skyrocket over the last few years, thus lowering the risk and in turn lowering the amount of return (including but not limited to Cap Rates) required by investors to enter the market.

Best Uses and Examples

If looking at Cap rates on your own properties, there’s always a bit of wiggle room but obviously the higher the better. If you find that you’re lower than 4% it’s likely time to consider making some adjustments to be sure you don’t fall too far behind the market and get the most out of your investment.

As you work with the formula you’ll see fairly quickly that rents tend to move the needle the most, so it’s always important to be sure you don’t fall too far behind on that front.

I’ve provided links to a few examples below if you’d like to see how Cap rates might apply in different situations: