In real estate investing, doing your due diligence is crucial to minimizing risk and maximizing returns. Before you decide to purchase an income property, it’s crucial to do a thorough investment property analysis. You need to learn how to run the numbers to be able to confidently decide whether or not buying it is a smart decision. Whether you are investing in an Airbnb property or traditional rentals, one of the most important metrics to use in order to measure profitability is the cap rate. While many investors use the cap rate formula to analyze real estate deals, there’s no clear-cut answer to the question “What is a good cap rate”
In this article, we will provide an approximate answer to the question “what is a good cap rate for a residential rental property?” But before we dive into that, let’s briefly explain what cap rate means in real estate.
Related: How to Buy the Best and Most Profitable Rental Properties
What is Cap Rate in Real Estate?
Cap rate in real estate is the ratio of the net operating income (NOI) of an investment property to its fair market value, expressed as a percentage. Net operating income is calculated by deducting the annual rental operating expenses of the rental property from the annual rental income.
It measures the expected rate of return on an investment property when purchased with cash. Since it doesn’t take into account the financing method, the capitalization rate is usually the most common return on investment metric used by investors to quickly compare multiple investment properties.
The cap rate formula is as follows:
Cap Rate = Net Operating Income/Fair Market Value × 100
What is a Good Cap Rate for Rental Property?
Theoretically, the cap rate is also a measure of the risk level associated with an income property. Generally speaking, the higher the cap rate the higher the risk level. Therefore, when answering the question “What is a good cap rate for rental property”, you should take into account both the expected return on investment and the risk level. To maximize return and minimize risk, you want a cap rate that is not too high or too low.
According to most real estate experts, anything in the range of 4% to 10% is a good cap rate. However, this is only a rough estimate. If you want to determine what is the acceptable cap rate for a particular property, you need to look deeper. Opinions on what is considered a good cap rate for rental property vary widely because several factors affect the variables that go into calculating the cap rate. You need to take these elements into account when determining what a good cap rate is.
Factors that Affect Cap Rate
Let’s look at three of the key elements that go into answering “What is a good cap rate for rental property?”.
1. Property Type
The rental property cap rate can differ according to the proper type. For instance, single family homes tend to have higher cap rates than multifamily properties. As you would expect, these investments are generally riskier and If the tenant fails to pay their monthly rent, there is no rental income that month.
However, if one or two tenants in a ten-unit apartment building fail to pay their monthly rent, there will be minimal change in the cash flow for that month. As opposed to single family homes, it is rare for a 100% vacancy rate to be experienced.
Related: What Is the Best Type of Investment Property in the Real Estate Market?
2. Location
Location is a critical aspect of real estate investing
What is considered a good cap rate will differ depending on location. State, cities, and neighborhoods have varied rental property cap rates. Different markets have different conditions which, in turn, affect the variables that go into calculating cap rate. For instance, busy urban markets typically have higher property costs than sparsely populated suburban and rural areas. This translates to lower cap rates in urban markets.
Broadly speaking, the average cap rate for your target market should be the minimum when buying an investment property. To determine the optimal rental strategy in a particular area based on cap rate, you need to compare the average Airbnb cap rate and average traditional cap rate for the area.
Let’s look at some cities in the US housing market that boast the highest cap rates for Airbnb and traditional rental properties. These lists are based on Mashvisor’s latest cap rate by city data.
Traditional Cap Rates by City
- Butler Township: 8.29%
- Eight Mile: 6.76%
- Marion: 6.69%
- Gary: 6.17%
- Camden: 5.9%
- Toledo: 5.83%
- Minot: 5.43%
- Moss Point: 5.23%
Airbnb Cap Rates by City
- Wakefield: 9.23%
- Beaumont: 8.45%
- Camden: 8.08%
- Covington: 8.07%
- Levittown: 8.04%
- Chesterfield: 7.95%
- Modesto: 7.89%
- Lansing: 7.14%
Related: Location Location Location: What Makes For the Best Place to Invest In Real Estate?
3. Timing
To answer the question “What is a good cap rate for rental property?”, you should also consider the current state of the housing market. If you are buying in a seller’s market, cap rates will generally be lower than usual because of increased property prices. For markets experiencing changes in supply and demand, what is considered a good cap rate will also change. For instance, what is considered a good cap rate for rental property will be higher in a buyer’s market than in a seller’s market.
As we have seen, the answer to the question ” what is a good cap rate for rental property” varies depending on a number of factors. Therefore, the cap rate should only be used to compare the rate of return of similar properties in the same area at a particular time. For instance, the cap rate cannot be used to decide between buying a three-unit apartment in Boston or a single family home in Los Angeles.
The Bottom Line
Cap rate is an important metric used by investors to locate profitable markets and properties. While real estate experts recommend a range of 4% to 10%, investors need to take into account a number of factors such as location and property type to answer the question “What is a good cap rate for rental property?”
Apart from cap rate, you should also look at other real estate data such as property price, cash flow, occupancy rate, and cap rate before you make an investment decision. With Mashvisor’s real estate investment tools, you can gain access to all the crucial data you need to make smarter investment decisions. With Mashvisor’s tools, you can locate the most profitable markets and investment properties for sale in a matter of minutes.
To get access to our real estate investment tools, click here to sign up for a 7-day free trial of Mashvisor today, followed by 15% off for life.