What is a good cap rate?- A question almost as old as the concept of real estate investing itself.
Because this question comes up so often in the search for the best real estate investment in the housing market, we’re all accustomed to hearing the same answer: “What is a good cap rate?” “Why, a good cap rate is anywhere between 8-12%!” And all of the real estate investors walk away satisfied.
But what happens when those same real estate investors actually begin their investment property search? How many real estate markets across the US housing market actually have an average cap rate between 8-12%? What do investment properties with that kind of cap rate even look like?
While real estate investing is grounded in principles and basics that are “immortal”, the numbers of the ever-changing real estate market simply are not. What is a good cap rate today is not the same as a good cap rate 20 years ago. So how is it that we have been hearing the same answer to “What is a good cap rate?” all of these years?
Forget everything you’ve heard about what is a good cap rate and come with me to explore what a good cap rate actually is in today’s real estate market.
But first…
The Basics of Cap Rate
What is a Cap Rate?
The cap rate, or capitalization rate, is a way for real estate investors to gauge the kind of return on investment they will get on an investment property. This real estate metric takes into account the annual net operating income (NOI) and compares it to the purchase price of the investment property. The cap rate doesn’t, however, include investment property financing as part of the investment property expenses subtracted from the rental income to get the NOI.
Another, more simple way to look at the cap rate is as a measure of risk in real estate investing. The higher the risk you will be taking on with a real estate investment, the higher the cap rate. The lower the risk with the real estate investment, the lower the cap rate (in theory).
How to Calculate Cap Rate
The cap rate formula is:
Cap Rate = Annual Net Operating Income (NOI)/ Property Price
Rather than worry about the above cap rate formula every time you wish to investigate the return on investment potential for an investment property, use a cap rate calculator. When it comes to calculating cap rate and even answering what is a good cap rate, no other real estate investment tool compares. The cap rate calculator will show you cap rates by city and by neighborhoods within a city. Once the cap rate calculator leads you to a real estate market with a good cap rate, it will show you cap rates for individual investment properties.
Real estate investors already have to worry about finding a good cap rate. Why should they also worry about calculating cap rate? They shouldn’t.
Check out the ultimate cap rate calculator today. To start your 7-day free trial with Mashvisor and subscribe to our services with a 15% discount after, click here.
What is a Good Cap Rate…Really?
Real estate investors, especially beginners, expect a number as the final answer for what is a good cap rate. Things just aren’t that simple. The answer “8-12%” is given to simplify real estate investing in a way. What happens though, is sometimes beginner real estate investors find an investment property with a 12% cap rate. They jump at the chance of buying an investment property with such a high cap rate. What does this theoretical investment property look like? Let’s take a closer look at this example.
As mentioned, not many real estate markets in the US housing market 2018 have an average cap rate of 12%. This real estate investor probably found a real estate market with an average cap rate of 5%. When looking for investment properties, one popped up advertised with a 12% cap rate.
Related: What is a Good Cap Rate for Real Estate Investments?
Cap Rates: What are We Missing?
From what this real estate investor has been lead to believe, this investment property will make him/her a ton of money. Right? Not really.
What this real estate investor forgot to ask is, that in a real estate market with an average cap rate of 5%, why does this one investment property have such a high cap rate? This high cap rate means the property price is pretty low compared to the NOI. And everyone, whether you have experience in real estate investing or not, should know to always question exceptionally cheap products, including investment properties.
It’s likely no other real estate investor would touch this investment property for a cap rate of 5% (a higher price, let’s say). It could have a number of different faults: bad structure, an awful neighborhood in an otherwise great real estate market, etc. Basically, this is a high-risk investment property. While we love saying “the higher the risk, the higher the profit”, it just isn’t always true in real estate investing. Something like a bad, crime-ridden neighborhood can’t be turned around to make for successful real estate investing. This investment property with the highly recommended 12% cap rate? It’s a dud. It’s worse than a dud. It’s a money drainer. The real estate investor might have been better off with a cap rate of 5%.
While this is an extreme example of real estate investing (and not necessarily the only scenario), it can and has happened. So, why is finding out what is a good cap rate so hard? It’s because cap rate is affected by so many variables.
What Affects a Cap Rate?
Three things affect a cap rate of an investment property and the risk factor: the location in the real estate market, the type of investment property and even interest rates.
For the real estate market, everything from the economy to the population growth to the level of education of the population can affect an investment property and its cap rate. With types of investment properties, it all depends on the demand in the real estate market. The higher the demand, the lower the cap rate, the lower the risk. With interest rates, as they go up, so do cap rates. This is because they affect the ability of real estate investors to pay back the mortgage or even take out a mortgage on an investment property, forcing property prices to go down if anyone wishes to sell.
Are any of these elements carved into stone? Absolutely not. So, it makes no sense to keep telling everyone the answer to what is a good cap rate is the same range: 8-12%.
Need More Proof of What is a Good Cap Rate?
Just to drive the point home, let’s take a look at the cap rate of one of the best cities to invest in rental properties in the US housing market 2018. In combination with a list provided by Forbes in February 2018 and our cap rate calculator, you can see that the first of the best cities to invest in this year has a pretty low cap rate. Even a “bad cap rate” compared to the traditional 8-12% range.
To learn more about our cap rate calculator, click here.
Orlando, FL
Traditional Cap Rate: 1.97%
Airbnb Cap Rate: 0.72%
Yet, real estate experts are telling real estate investors to go invest in the Orlando real estate market. Why? Because real estate investing is so much more than a numbers game. And even if it was, cap rate would not be the ultimate contender in that game.
So, What is a Good Cap Rate?!
We haven’t quite answered the question yet. And, unfortunately, we won’t give you a number to satisfy you. Sometimes 1% is a good cap rate. Sometimes 5% is a good cap rate. Sometimes 12% is a good cap rate. The only way around this is to not use cap rate as a deciding factor in choosing the best real estate investment.
Does this mean cap rates have become obsolete? No. You should use cap rates to make a well-rounded decision along with cash on cash return, rental income, occupancy rate, and purchase price (our cap rate calculator shows all of these things for real estate markets and investment properties). This means studying the real estate market, performing real estate market analysis and eventually investment property analysis. Get a home inspection done as well. All of these things are much more important to the big picture of successful real estate investing.
To start looking for and analyzing the best investment properties in your city and neighborhood of choice using a cap rate calculator, click here.
Use cap rates as a guide. A cap rate calculator can reveal the cap rate for a real estate market. Look for investment properties that have a similar or higher cap rate, but always continue with real estate investment analysis and be wary of extremely high cap rates. Don’t write off an investment property with a low cap rate either as it might be a low risk real estate investment with steady rental income.
What is a good cap rate? It depends.
The question you should ultimately be asking: How Can You Recognize the Best Real Estate Investing Opportunities Out There?