Understanding the cap rate formula can help investors succeed in real estate investing. What is the cap rate? How is it calculated? What factors affect the cap rate? What is considered to be a “good” cap rate? All these questions and more are typically asked by real estate investors when they are searching to find the best real estate investments.
What is the cap rate?
The cap rate formula is the most commonly used formula for calculating the rate of return for an investment property. Real estate investors use the cap rate formula to determine if a certain investment will be worthwhile or not. So what is cap rate? Basically, the cap rate formula is used to show the rate of return for an investment property’s rental income in relation to the current market value for that property. It is a metric that shows how much profit your property will make as a percentage of the current market value.
How is cap rate different from cash on cash return?
It’s important to mention the difference between cap rate and cash on cash return. Both are used to measure the rate of return on investment. However, there are minor differences between them. The cap rate is used to tell investors how much profit they would generate from an investment property if they paid for it all in cash. The cash on cash return tells investors how much they would make based on the actual cash invested.
Unlike the cap rate, the cash on cash return takes into consideration the annual financing costs for the property or “annual investment.” The cap rate does not factor in any financing costs. In the calculations for cash on cash return, financing costs are included as an expense, but in cap rate calculations, they are not.
Related: Cap Rate vs. Cash on Cash Return
How to calculate cap rate
Before you know how to calculate cap rate, you need to know the cap rate formula and what metrics it consists of. The cap rate formula is:
Cap Rate = (Net Operating Income / Current Market Value) x 100%
The net operating income is the difference between the annual rental income and the annual rental expenses of your investment property.
NOI = Annual Rental Income – Annual Rental Expenses
The annual rental expenses are the costs associated with operating the investment property which may include insurance costs, maintenance costs, and taxes. The current market value is basically the price of the property.
Example on how to calculate cap rate using the cap rate formula
Time for a quick math class! Let’s assume you find a rental property worth $250,000. If you rent out the property for $2,500, this would mean that your annual rental income is $30,000. An estimation of running costs for your property is $6,000. How much would your property’s cap rate be?
Cap Rate = ($30,000 – $6,000) / $250,000 = 0.096 = 9.6%
Cap Rate = 9.6%
This means that the property’s annual cash flow is equal to 9.6% of the property’s total value. The question that remains: Is this considered a good cap rate for an investment property?
What is considered a good cap rate?
This is a debatable answer. While some investors would argue and say no, it is not a good cap rate, others will find this percentage very lucrative. Generally speaking, anything from 8-12% is considered “good.” There are many factors that affect the cap rate formula and the range of what is a good cap rate for investment properties varies depending on these factors. Let’s take a look at what factors affect cap rate.
Related: How to Calculate Cap Rate for Rental Properties Most Efficiently
What factors affect the cap rate formula?
1. Location
It should be no surprise that the location of your investment property affects the cap rate. Location plays a vital role in the success of every investment property in the real estate market. You need to look for areas that are high in demand for investment properties. Look for areas with high employment rates, high median home prices, and a good economy. These factors tend to increase the demand for real estate investments.
To help make your search easier, use Mashvisor’s rental property calculator and property finder tool. With Mashvisor’s property finder tool, you can find the best-performing properties that offer the highest cap rates in your selected city/cities of choice.
Do you have a free Mashvisor account? Click here to use our Property Finder and find properties in a matter of minutes!
Related: Best Places to Invest in Real Estate Based on Cap Rate
2. Rental strategy
The rental strategy you choose affects the percentage of the cap rate for your rental property. How? Well, you have two main rental strategies to choose from: long-term rental (traditional rentals) or short-term rentals (Airbnb rentals). Airbnb rentals tend to generate higher rent compared to traditional rentals. Moreover, traditional rentals cost less in rental expenses than Airbnb rentals. That is why the results you get from the cap rate formula will vary depending on your chosen rental strategy.
3. Property type
The type of investment property affects the cap rate as well. Multi-family homes tend to have higher cap rates than single-family family homes.
Like I said before, the cap rate formula is very important and must be used by real estate investors when selling or buying investment properties. Finding the best places that offer high cap rates can be tricky, but with the right real estate investment tools, your search can be easy. Here is a list of the top cities with the best cap rate in 2018.
Note: The numbers below were taken from Mashvisor’s data and rental property calculator.
Top cities for the best cap rate for Airbnb rentals:
#1. Nashville, Tennessee
- German Town: 12.01%
- Melrose: 8.03%
- The Gulch: 7.74%
#2. Baltimore, Maryland
- Old Town: 10.94%
- Heritage Crossing: 7.86%
- Mount Vernon: 3.85%
#3. Kansas City, Missouri
- South Hyde Park: 8.22%
- Old Westport: 3.22%
#4. Orlando, Florida
- Millenia: 8.76%
- Florida North Center: 3.17%
#5. Las Vegas, Nevada
- Huntridge: 7.08%
- Rancho Charles: 5.86%
- Winchester: 5.64%
Top cities for the best cap rate for traditional rentals:
#1. Baltimore, Maryland
- Old Town: 6.99%
- Heritage Crossing: 6.64%
- Pleasant View Garden: 6.36%
#2. Nashville, Tennessee
- German Town: 5.21%
- Edgehill Community Garden: 3.03%
#3. Oakland, California
- Shafter: 9.52%
#4. New Orleans, Louisiana
- Central City: 5.27%
#5. Las Vegas, Nevada
- The Strip: 5.69%
Read Also: Traditional Rental Strategy: Go for These Cities for Cap Rate
The bottom line
Understanding the cap rate formula is crucial for every real estate investment. Before buying or selling investment properties, always search for the locations that offer the best cap rates to ensure you get the most profitable investments. Mashvisor provides investors with the best rental property calculator which is accurate and covers any neighborhood you’re interested in. Mashvisor’s calculator uses predictive analytics and historical data to find the best investment opportunities out there.
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