With a proper foundation, you can succeed in real estate with a rental property. Every real estate investor, therefore, needs to be knowledgeable on real estate essentials. In today’s blog post, we’ll help you achieve just that. Let’s get back to the real estate basics by examining the cap rate.
What Is a Cap Rate in Real Estate?
Short for capitalization rate, the cap rate is a return on investment (ROI) metric that determines an investment property’s profitability. Unlike cash on cash return, the cap rate expresses profit regardless of rental property financing. The capitalization rate is usually presented as a percentage, similar to other ROI metrics.
Both traditional and Airbnb real estate investors scour the housing market for a good cap rate for investment properties. But before we take a look at what is a good cap rate, let’s review how this property metric is calculated.
Related: Cap Rate vs Cash on Cash Return
How to Calculate Cap Rate
Calculating the cap rate can be complicated and there are easier (and quicker) ways to get the cap rate for a rental property without doing the math yourself. Still, it’s very useful for real estate investors to know how to calculate cap rate.
Here’s the cap rate formula. We’ll also provide an example.
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Cap Rate Formula
The cap rate formula is:
As you can see, calculating cap rate depends on two variables.
The first variable is NOI, short for net operating income. NOI is the difference between an investment property’s annual rental income and annual operating expenses. As the name implies, annual rental income is simply monthly rental income multiplied by 12. Operating expenses, on the other hand, is the sum of all costs and fees associated with running an investment property. Common examples of operating expenses include insurance, property taxes, repairs, maintenance, utilities, and more. The operating expenses used to calculate NOI, however, do not include costs that are specific to the real estate investor, such as mortgage principal and interest, income taxes, and depreciation. This makes sense, given that the cap rate is meant to calculate profitability regardless of financing. As a result, an investment property purchased with cash or a mortgage will have the same cap rate.
FMV or fair market value is the second variable in the cap rate formula. It refers to the value of investment property during a certain period of time. In other words, FMV is the selling price of a property at the time of cap rate calculation.
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An Example of the Cap Rate Calculation
Let’s test your math skills! You own a single family rental property that generates $2,000 in monthly rental income and $400 in monthly operating expenses. If the investment property’s FMV is $250,000, what is its cap rate?
Cap Rate = [($2,000 x 12 months) – ($400 x 12 months) ÷ $250,000] = 0.0768 = 7.68%
What Is a Good Cap Rate for Rental Property?
So, is 7.68% considered a good cap rate? What is a good cap rate for rental property, anyway? Generally speaking, the answer is anything from 8% to 12%. Nonetheless, the better answer is not as straightforward. The reason why is that the range of what is a good cap rate varies based on many factors.
What Is a Good Cap Rate? – Influential Factors
You’ve likely heard this a thousand times, but the three most important things in real estate are location, location, and location. It should, therefore, be of no surprise that a rental property’s cap rate is influenced by its location. And because cap rates by city vary greatly, what is considered a good cap rate changes from one location to another.
Related: Location, Location, Location – Is Location Really All In Real Estate Investing?
The second influential factor is the rental strategy. Airbnb vacation homes, for example, usually earn more rental income than traditional rentals. This is because Airbnb rentals are rented out on a nightly basis, as opposed to long-term leases. As a result, a good Airbnb cap rate is higher than a traditional one.
Property types also play a role. Multi-family rentals with multiple sources of rental income typically have higher cap rates than single-family and townhouse rental properties.
In addition, there is sometimes a tradeoff between risk and high cap rates. In high cap rate cities, a real estate investor might find that investment properties are in bad condition, accounting for the low property value which leads to a higher cap rate (review the formula above!). Lower cap rate, in this instance, indicates lower risk. So, this answers the question of “is a higher cap rate better?”.
You can now see that fully defining what is a good cap rate is no easy task. For some experts, as long as an investment property produces positive cash flow, you can afford it, and it has the potential to appreciate, then the cap rate doesn’t have to fall in the 8% to 12% range. Nonetheless, what’s most important is to determine what a good cap rate for a real estate market is, taking the above factors into account. A cap rate analysis of the area and real estate comps will produce the most accurate baseline to follow. More on this below!
Why Is Cap Rate Important?
So far in this blog, we’ve discussed what is a cap rate in real estate, how to calculate cap rate, and what is a good cap rate. We’ll now talk about why knowing all of this information about the cap rate is so important in the first place.
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Understand Potential Return on Investment
The main function of the cap rate is to act as a return on investment metric. Quite simply, the cap rate helps real estate investors determine how profitable their investment properties are or will be.
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Quickly Compare Rental Properties for Sale
As an ROI metric, the cap rate is also used to compare property listings. High cap rate properties for sale will, generally speaking, be more lucrative than others. Of course, this depends on some of the factors mentioned earlier.
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Estimate Payback Period
Finally, the cap rate can be used to estimate a property’s payback period. In other words, it can project how long it will take the investment property to pay back all of the money that was put into it. In order to get this estimate, simply divide 100 by the cap rate of the income property.
Related: Real Estate Investment Payback Period: A Beginner’s Guide
How Can You Calculate Cap Rate Quickly?
Now that you know the essentials of what is a cap rate in real estate, you need to know how to quickly calculate it. Being able to look at the cap rate for any rental property for sale in the US housing market without having to gather data and do the math will make the number much more useful during an investment property search. Additionally, calculating cap rate manually is very prone to error and energy-wasting, especially when you attempt to find the cap rate for multiple properties at once. The solution is to use Mashvisor’s cap rate calculator. This tool automatically calculates traditional and Airbnb cap rates for all property listings. To get your hands on Mashvisor’s cap rate calculator, CLICK HERE to start a 7- day FREE trial with Mashvisor!