Real estate investing can be daunting. Every step of the process introduces concepts and complications that you may not be familiar with. It is important to identify the important ideas while also acknowledging that certain things can be revisited later.

But cap rate is one of the metrics you should understand!

# What is a "Cap" (Capitalization) Rate?

A real estate investment's cap rate is the net operating income (NOI) generated by a property divided by the property's acquisition price or current market value.

![Cap rate](//images.ctfassets.net/1mjp7lib98gn/55sYwqywV3AtqJCDzdnkfM/acf4023051ebfc74e777c50d19f33ba5/Screen_Shot_2022-03-02_at_8.48.04_PM.png)

*__Cap rate = Net operating income (NOI) / Acquisition price (or current market value)__*

Let's break that down in more detail by looking at an income statement for a hypothetical but realistic property.

![Annual income by year](//images.ctfassets.net/1mjp7lib98gn/50e9gxbbLDgfvZBCzeI8BF/2bb66074f949c43e0eb01fa48dead641/Screen_Shot_2022-03-02_at_8.32.52_PM.png)

## Calculating NOI

Net operating income (NOI) is half of the cap rate equation and often requires subjectivity or estimates when evaluating a potential investment.

__Gross income:__ Gross income is the in-place or projected rental income generated by a property before vacancy. Property's will often have existing tenants in place that a buyer will absorb. If the property (or a unit within the property) is delivered vacant, the buyer can estimate market rent for 1-4 unit residential real estate using tools such as Rentometer or Zillow.

__Vacancy expense:__ Vacancy expense is the estimate of lost rent that will be caused by delays renting or vacancy. It is calculated by multiplying the percentage of an average year you expect the property to be vacant (often 3 - 10% for 1-4 real estate) by the gross income prior to vacancy

__Effective gross income:__ Gross income - vacancy expense

__Capital expenditures (capex):__ Capital expenditures (or "capex") represent expenses incurred that have long useful lives and/or increase the value of a property, such as a new roof or a new water heater. Capex expense will vary significantly from property depending on factors such as building age, previous upkeep, geographic location, tenant quality and more. It will also vary significantly from year to year, so when analyzing an investment real estate investors will often use a multi-year blended estimate.

__Repairs and maintenance (R&M):__ Repairs and maintenance represents non-capex expenditures, such as calling the plumber for a leak or patching some siding. It will also vary significantly by property and year, though it is slightly more predictable than capex.

__Taxes:__ Taxes are fairly self explanatory and can be found directly on Zillow or Redfin, then verified on the county or state website. One thing to look out for is tax reassessments, which may be triggered on sale and substantially increase a property's annual tax burden relative to the existing cost.

__Insurance:__ There are many types of insurance, but the two most common are general homeowner's insurance and flood insurance. Many investors have a rule of thumb for homeowner's insurance, but flood insurance can vary greatly based on location / flood zone, so investors should check to see if a given property is in a FEMA flood zone while analyzing an investment.

__Property management:__ Property management represents the cost paid to third parties to manage the property. For 1-4 unit real estate, it often pencils to somewhere between 6 - 15% of rental income.

__Other expenses:__ Every income statement needs a catch-all category for expenses not encapsulated in the above categories. Common 1-4 unit other expenses include any utility responsibility, garbage and HOA.

__Net operating income (NOI):__ With all expenses determined, you can now calculate NOI by subtracting all expenses from estimated gross income.

## The numerator: Acquisition price and/or market value

Depending on the type of analysis you are doing, the bottom half of the cap rate equation can take many forms.

__When to use purchase price:__ If you are buying a property without doing any significant rehab work, use purchase price in your cap rate equation.

__When to include rehab expenses:__ If you plan to rehab a property, use purchase price + estimated rehab costs + X% contingency. 

__When to use current market value:__ If you are calculating cap rate for a property in your portfolio or listing a property for sale, use current market value.

# Using cap rate to analyze real estate investments

Now that you know how to calcualte cap rate, you can [use CF Analyzer to quickly calculate cap rate for a potential investment](https://cfanalyzer.com/analyze "Analyze a property!") and compare the result to other properties in the same market.

If you analyze 50 deals and they all have a cap rate between 5.25% and 5.75%, but then you find one that has an estimated cap rate of 7% --> either something is way off (tread carefully!) or you've found a great deal.

# Using cap rate to determine a property's value

Pop quiz: If you have a property generating $30,000 in NOI and the market cap rate is 5%, how much is your property worth?

Answer: $30,000 / .05 = $600,000

So cap rate can also be inverted to determine property value.

# Using sensitivity analysis to analyze an investment

As an investor in 2022, I often finding myself saying "Man, that house is *__way__* overpriced" and wondering what a fair price is. While it is impossible to know what "fair" is in this market, you can use sensitivity modeling to quickly determine what a fair price is if:

* You know in-place rent or are able to accurately estimate market rent
* You know what the market cap rate is for your submarket and asset class (ex: ~5% in Jersey City, NJ)

![How purchase price and rental income affects cap rate](//images.ctfassets.net/1mjp7lib98gn/6PKXHNM2ZHkTDLvTj4Pfs2/b1bcfb78a2d3a0ffcab1b2d061980cad/screencapture-cfanalyzer-analyze-2022-03-02-21_42_50.png)

By analyzing various purchase price and rent combinations simultaneously, you can quickly determine what a house is actually worth and decide how much to offer.

Make sure to [try out CF Analyzer](https://cfanalyzer.com/analyze) in order to see the sensitivity analysis tool in action.

# Summary

Capitalization rate is a fundamental metric used to analyze real estate investments and now that you know how to calculate it you can use it to compare properties to each other, identify which ones to offer on and determine how much to offer.

[Calcualte cap rate and analyze a property using CF Analyzer now!](https://cfanalyzer.com/analyze)


What is a "Cap Rate" in real estate investing and how is it calculated?

*"I went to an open house and there were 50+ people there"*

*"We've received 27 offers, highest and best is due by 5pm"*

*"If you agree in writing to name your firstborn child after my hero, Elvis Presley, maybe we will consider your offer."*

Ok fine, I didn't actually hear the last one. But by now we all have heard about how crazy the market is. And it's true: the market is insane.

Supply is at an all time low:

![Supply all time low](//images.ctfassets.net/1mjp7lib98gn/19pyF3MF20HnzECuYMSfJB/d5fa791188b841ec7d91d0d77f0fd056/Screen_Shot_2022-03-02_at_10.13.35_PM.png)

Prices are still near record highs:

![Record high prices](//images.ctfassets.net/1mjp7lib98gn/4KEFEpdvzREBU9sZf1SICg/992ff6b44ff745f1eed6e6c3e84fea24/Screen_Shot_2022-03-02_at_10.15.15_PM.png)

*[Images from Greater Boston Association of Realtors January 2022 update](https://www.gbreb.com/GBREBDocs/GBAR/News/Housing-Market-Data/2022/GBAR-Monthly-Market-Insight-Report-Jan%2022-final.pdf)*

__So is it possible to find a cash flow positive real estate investment in Boston in this market? Here's what I am seeing by submarket:__

__Not possible:__ Cambridge, Back Bay, North End, South End, Charlestown, etc (you likely know the suspects by now)

__Long-shot but possible:__ East Boston, Chelsea, Roslindale, Jaimaica Plain, Allston, Everett, Medford

__Pockets with some potential cash flow:__ Malden, Dorchester, Revere, Quincy, Milton

This list isn't inclusive of every city or neighborhood, just a snapshot of what I'm seeing as I look at properties.

__And as you look further outward you find some towns with cash cows:__ Lowell, Worcester, Brockton, Fall River, New Bedford, etc.

# So what happens next?

Personally, I think it is unlikely we see a major correction in 2022. Supply is just too low and demand continues to stay strong even as rates rise back past 4%. But it is impossible to know for sure -- the uncertainty in the bond market could be the spark that shakes things up and causes a correction.

*If anyone is interested in investing or house hacking in the Boston area shoot me an email. In addition to building CF Analyzer, I'm an active agent and love talking real estate: [tom@househackboston.com](mailto:househackboston.com)*

2022 forecast: Boston real estate investing and house hacking market

There are a lot of places you can go to learn about real estate online. From Bigger Pockets to YouTube to podcasts to Twitter, we are all overwhelmed with a deluge of content to choose from on a daily basis.

Sadly, most of this content is garbage.

You'll often find wholesalers pitching their course instead of trying to wholesale deal and "investors" talking their book instead of unearthing and stabilizing great deals.

This blog will be neither of those things. Instead, we will focus on a broad range of topics in extreme detail, such as:

* Calculating net operating income (NOI) and cap rate
* How to determine market rent
* Running comps
* Estimating expenses
* Investing for appreciation vs investing for cash flow

More to come -- stay tuned!