The reason why people invest their money in real estate properties is to make even more money. That’s why return on investment is a crucially important concept in real estate investing for beginners. There are many different ways to measure profit in rental property investment, each with each pros and cons. The capitalization rate, or cap rate for short, is one of the most widely and easily used metrics of return on investment in income properties.
In this article, we have the cap rate explained in full detail so that even beginner real estate investors can make smart, educated decisions and find lucrative traditional and Airbnb rental properties in the US housing market.
To learn even more on what is a cap rate in real estate, watch our latest video available below.
What Is Cap Rate in Real Estate?
Let’s start right away by answering this important question: “What is a cap rate in real estate investment?”
According to the cap rate definition, this is a measure of the rate of return on a rental property. Experienced real estate investors use this metric to calculate the return which they can expect to generate on an income property.
Meanwhile, the capitalization rate also measures the risk associated with a real estate investment. After all, just us with any other investment strategy, a higher profit comes with a higher risk.
While the cap rate concept is mostly used in commercial real estate investing, it is very useful for evaluating return in residential real estate investments as well. Because of the simplicity of the cap rate formula, as you will see in the section below, this metric constitutes a great way to compare the expected rate of return on different markets as well as different rental properties for sale.
How to Calculate Cap Rate for Rental Properties?
Another key question to answer is: “How to calculate the capitalization rate of residential investment properties?”
Unlike other return on investment metrics, the cap rate comes with an easy formula which factors in only a few variables.
Cap Rate Formula
For newly bought rental properties:
Cap Rate = NOI/Purchase Price
For previously purchased rental properties:
Cap Rate = NOI/CMV
where
NOI = Net Operating IncomeCMV = Current Market Value
In other words, the capitalization rate is calculated by dividing the net operating income (NOI) of an investment property by the sale price or the current market value (CMV).
The net operating income, on the other hand, is the difference between the rental income and the necessary operating expenses for running a rental property. The operating expenses include property tax, property insurance, maintenance, property management, cleaning fees, and utilities.
As you can see from the formula above, the capitalization rate seems easy and quick to calculate. Indeed, it is much more straightforward to use than other profitability metrics in real estate investment, which is why it is so widely spread.
However, when you start calculating the cap rate of multiple real estate markets and numerous investment properties for sale to choose the best one, you will realize that it still requires lots of real estate market analysis including rental market analysis and investment property analysis.
You need these types of real estate analysis in order to find real estate comps and rental comps to estimate what rental income you can expect from a property as well as what your recurring expenses would be.
The most time- and cost-efficient way to find the cap rate on any property in the US housing market is to use Mashvisor’s real estate investment tools. With the search app, you can look for rental properties within your expected cap rate range in any US city and neighborhood. With the investment property calculator, you can get readily available estimates of the return on investment of any property, whether available on our real estate investment software platform or not.
To start searching for money-making traditional and Airbnb rental properties, sign up for a 7-day free trial of Mashvisor now.
What Are the Pros and Cons of the Capitalization Rate?
When starting investing in real estate, it is important to decide what metrics you will use to assure that you make profitable decisions. That’s why a beginner real estate investor should know the pros and cons of different measures.
When it comes to the capitalization rate, the chief benefit is that it is basically the easiest measure of return to calculate. Although you need reasonable and reliable estimates of the rental income and operating expenses, other metrics need even more estimations.
With regards to the shortcomings of the cap rate formula, it is important to highlight that this measure does not take into account the method of financing rental properties. Whether you buy an investment property in cash, with a conventional mortgage loan, with an FHA loan, with a private loan, or with hard money lenders money, the capitalization rate will be the same.
Thus, in order to make up for this omission, it is best to use the cap rate in combination with the cash on cash return, or CoC return for short. This is another major metric of return in real estate investing.
To find investment properties with a high cap rate and cash on cash return in any US housing market, sign up for a 7-day free trial of Mashvisor today.
What Is a Good Cap Rate for Investment Properties?
As mentioned above, the capitalization rate measures not only the profit but also the risk associated with buying a rental property. That’s why it is wrong to search for properties with the highest cap rate possible because this might inflate the risk unnecessarily.
The perfect balance between return on investment and risk is achieved with a cap rate of 8-12%. That’s what’s considered a goop cap rate in real estate investment.
Wondering what rate of return you can get in the US housing market at the moment? Read 2020 Cap Rates by City: What Real Estate Investors Should Expect.
How Can You Find Profitable Investment Properties?
The questions and answers above provide a lot of information, but those new to real estate investing might still be unsure of how to find traditional and Airbnb rental properties with a good cap rate (as well as a good cash on cash return).
The optimal way to do this is with Mashvisor’s cap rate calculator. This real estate investment tool eliminates the need to perform manual neighborhood analysis and rental property analysis by offering readily available estimates of the return on investment on income properties. Importantly, all measures are based on the actual performance of traditional and Airbnb rental comps in the area, which makes them highly accurate and reliable.
Related: How to Find Reliable Traditional and Airbnb Rental Comps
This is the cap rate explained. Our recommendation to beginner real estate investors is to use this metric to compare locations and multiple properties. However, when deciding among a few properties that you have narrowed down, you should enrich your investment property analysis with estimates of the expected cash on cash return as well to assure profitable real estate investing decisions.
To get access to all the real estate data and analytics that you need for this purpose, sign up for a 7-day free trial of Mashvisor today.
Related: Mashvisor’s Real Estate Data and Analytics: Must-Have for Investors