Understanding Cap Rate Real Estate: The Complete Investor’s Guide in 2023

The best way to make passive income in 2023 is through good cap rate real estate investment properties. But what is this and how is it done?

For every real estate investor, the cap rate is one of the most important metrics to understand and calculate when buying a rental property. That’s because this metric shows you not only what ROI to expect but also what risk investing in this property entails. In other words, that’s the best way to ensure that you’ll make enough money without taking too much risk.

Table of Contents

1. What Is Cap Rate in Real Estate?
2. 6 Factors That Affect the Cap Rate
3. How to Calculate the Cap Rate in Real Estate
4. Why Use a Cap Rate in Real Estate Investing
5. When to Use a Cap Rate in Real Estate
6. What Is a Good Cap Rate in Real Estate?
7. 10 Highest Cap Rate Cities for Long Term Rental Properties in 2023
8. 10 Highest Cap Rate Cities for Short Term Rental Properties in 2023

While we hear about cap rate all the time, many beginner investors are not sure how it is calculated and what goes into its formula. They don’t know when and why to use this measure over other return on investment metrics. They don’t even know what’s a good cap rate and where to find markets with optimal return levels in 2023.

If you belong to this group of investors—no worries! We’ve got you covered. In this article, we will go over everything related to cap rate in real estate investing to help you optimize your rental property investments. In addition, we will show you how the Mashvisor platform can help you find long term and short term rentals for sale with good cap rate levels.

So, just keep on reading.

What Is Cap Rate in Real Estate?

The capitalization rate in real estate, better known as the cap rate, is one of the most popular ways to measure return on investment on rental properties. What makes it the preferred metric for so many investors is the ease of calculating the cap rate real estate investment ROI, which we will discuss shortly.

The cap rate is the ratio of a rental property’s net operating income (NOI) to the value of the asset.

The NOI shows the gross income earned from a property within a period of one year minus all the required operating costs. In the case of renting out a single family home, for example, it is the monthly rent multiplied by 12 minus all rental expenses like property management, repairs, insurance taxes, etc.

The value of the rental, on the other hand, can be calculated either as the purchase price or the current market value.

We will provide the exact cap rate formula in a while.

However, in residential real estate investments, the cap rate doesn’t indicate the potential return only but also the level of risk associated with investing in a certain property. Every investment strategy, including real estate, stocks, cryptocurrency, gold, and others, comes with some risk (unfortunately). The best way to measure risk in real estate is through the cap rate.

Market-Level Cap Rates

The cap rate formula in real estate is not only useful in checking the investment potential of a specific property. It’s also used when it comes to the profitability of entire markets, including both cities and neighborhoods. As we all know, location is a key factor in real estate investing, and one of the reasons is that different locations yield different returns.

It’s important for investors to know that the cap rate in real estate is not fixed. Quite the contrary, it fluctuates based on property type, class, location, and many other factors. Moreover, it changes over time due to changes in rental demand, rental rates, rental expenses, and others.

6 Factors That Affect the Cap Rate

As the cap rate formula shows, there are a few different factors that affect the profitability of an income property based on this metric. While some of the factors are very intuitive, others are a bit more convoluted.

So, let’s look at the five most important things to consider when searching for real estate markets and rental properties for sale with a good cap rate.

1. Location

As always, location is the #1 factor in everything real estate-related, including the capitalization rate. Some real estate housing markets just yield higher ROI than others for a wide variety of reasons.

Most importantly, each location comes with its own unique median property prices and rental rates. Rental demand (for long term rentals) and Airbnb occupancy rate (for short term rentals) also vary from place to place.

So do the recurring rental expenses, depending on the cost of living. Markets with higher living standards require investors to spend more money on owning and running an income property there, and vice versa. Things like home insurance, property tax, and rental income tax are also different nationwide.

All the above means, at the end of the day, that some markets are more likely to achieve good cap rates while others are not.

Later in this article, we will help you locate the best markets for cap rate real estate investments in the US in 2023.

2. Property Type

The second factor that majorly affects the capitalization rate is the real estate asset type. In residential real estate investing, there are two major types of properties: single family homes and multifamily homes.

Of course, there are also townhouses, apartments, condos, and others, but for the purposes of cap rate real estate investments, they generally fall under the single family home variety. Meanwhile, duplexes, triplexes, quadruplexes, etc., can be considered multifamily properties.

Overall, multifamily real estate investing yields lower cap rates than its single family counterpart. The reason behind it is related to risk.

When you own a duplex or another small multifamily unit, even if one of the units remains vacant for a couple of months, the other(s) will continue generating some revenue. It means that you face a lower risk of negative cash flow.

Alternatively, if you rent out a property that can fit a single tenant or family at a time, your rental income will be zero if it’s not occupied. Meanwhile, you need to continue covering the recurring rental expenses, which puts you at a higher risk of negative cash flow and even foreclosure. That’s why single family property types tend to bring higher cap rates.

3. Investment Property Price

As we will see in the cap rate formula below, the purchase price of the rental property is directly present there. As the capitalization rate is the ratio between the NOI and the property sales price, how much you pay for your investment property is one of the main factors that determine ROI.

After all, if you are able to generate the same net operating income from two residential properties that cost differently, the cheaper one will bring you a better return on investment. You are making the same income while paying less to obtain the said asset.

4. Rental Rates

The next crucial factor determining your profitability as measured by the cap rate metric is the rental rate you charge long term tenants or short term guests. It is because the monthly or daily rental rate—together with the occupancy rate—is used to calculate the NOI, which is present in the cap rate real estate formula.

The higher the amount you’re able to charge for your rental property, all else held equal, the more money you will be able to make from your investment property. And vice versa—if your rental rate is low, your ROI won’t be much.

5. Real Estate Investment Strategy

Yet another factor that affects the capitalization rate in real estate investing is the rental strategy. Generally, short term rentals offer higher cap rate than long term rental properties. There are two reasons behind this reality.

First of all, short term rentals are rented out on a daily rate, so investors are able to charge higher nightly rates. It, in turn, leads to more monthly and annual rental income, provided that they are able to keep their property occupied for at least half of the time.

Second, while short term rentals for sale tend to bring higher income and profit, they are also associated with more risk as they need to be rented out on a daily basis. It means that you’re never guaranteed how much occupancy you will be able to get per month, which puts your income at risk as well.

Another risk related to this rental strategy is the constantly changing short term rental laws and regulations across the US housing market. Many states, counties, and cities are still adopting restrictive measures to curb the growth of the Airbnb rental industry in the local market. So, investors who go for this strategy might need to change course in a few years.

The combined effect of the two reasons explained above is that short term rentals are more profitable in terms of cap rate.

6. Time

Last but not least, cap rates change over time for the same market, property type, and real estate investment strategy. That’s because rental rates, occupancy rates/vacancy rates, rental income, and rental expenses all change over time.

Moreover, sometimes investors use the current market value of the income property instead of the purchase price in the cap rate formula, which is also prone to change over time.

It means that investors need to use the best real estate ROI calculator in order to ensure their strategy and approach make sense at any point in time. For example, they might need to adjust the rental rate from time to time. Or, they might need to enhance their rental marketing strategy. Otherwise, they risk a negative cash flow property.

How to Calculate the Cap Rate in Real Estate

Now that you know what factors affect cap rate real estate investments, it’s time to look at the exact formula how to calculate this ROI measure and how to use it in real life.

What Is the Cap Rate Formula in Real Estate?

Here is the formula real estate investors use to calculate the capitalization rate of long term and short term rentals for sale before buying them based on the definition provided above:

Cap Rate Formula

Cap Rate = NOI/Purchase Price x 100%

or

Cap Rate = NOI/Current Market Value x 100%

As you can see from the formula above, calculating the cap rate is relatively straightforward. There aren’t too many inputs that go into the formula.

Moreover, sometimes investors use the sales price of the property, and sometimes they use the current market price. Using the latter makes sense if you’ve owned the rental property for a while, as its value is likely to have changed significantly since the purchase.

Let’s take a look at a quick example:

Cap Rate Example

You’re interested in buying an investment property that is listed for $500,000, and its NOI is $75,000.

According to the definition:

Cap Rate = $40,000/$500,000 x 100%

Cap Rate = 8%

What does this cap rate of 8% mean?

We’ll see in a bit.

How to Calculate the Cap Rate the Traditional Way

In order to calculate the capitalization rate the way it’s been done for decades, investors need to manually gather all the data and numbers that they need in the formula. While the numbers seem few, each one requires solid data collection.

To estimate the net operating income, you need to know what rental rate you can charge, what occupancy rate to expect, and how much it will cost to run your rental business. All the said numbers are strictly related to your specific rental market, property type and size, amenities, marketing efforts, etc.

To obtain the required data before buying a property, you need to conduct detailed real estate market analysis and rental market analysis to collect real estate comps and rental comps.

Real estate comps relate to recently sold homes in the area that are similar to yours. It will show you how much you can expect to pay for your rental, as the purchase price is one of the inputs in the cap rate formula.

Rental comps refer to comparable long term or short term rental listings in your local market. You need them in order to see what long term rental income or short term revenue other investors are able to generate, as well as how much they spend on running their property.

The required market analysis, data collection, and calculations in Excel spreadsheets might become unsustainable if you’re considering a few different properties in several markets.

But there is a better way how to figure out what cap rate you can get from a property before purchasing it.

How to Calculate the Cap Rate With the Mashvisor Real Estate Investment Calculator

There is a considerably more efficient way to evaluate cap rate real estate investing opportunities through the advancement of real estate tech.

The Mashvisor real estate investing app features—among other tools—a cap rate calculator. It is a tool based on big data, AI, and machine learning algorithms. It looks at the performance of long term or short term rental comps in the area to calculate what capitalization rate you can expect on a property for sale.

The excellent thing about the Mashvisor investment property calculator is that it also allows you to look for MLS listings and off market properties for sale that match your criteria. You can set up a few basic filters like location, property price, expected rental income, and ROI to get a complete list of all available listings that match your expectations.

Each of them comes with a comprehensive rental property analysis, including all factors that go into the cap rate definition, as well as the actual cap rate. It means that with access to the Mashvisor platform, you don’t need to conduct manual real estate research and analysis. Instead, you can find properties with a good cap rate from the comfort of your computer.

To start analyzing the cap rate potential of investment properties for sale across the US residential market, click here.

Why Use a Cap Rate in Real Estate Investing

You should use the cap rate formula when investing in real estate rental properties for many different reasons.

It is such a popular metric for ROI because it provides a relatively easy way to compare different markets and different properties for sale. The cap rate real estate calculation is less complicated than other return on investment measures. It helps investors save time when comparing the potential of a few opportunities.

With the introduction of various tech-driven real estate investment tools, calculating cap rates on multiple locations and listings takes just a couple of minutes. Investors don’t need to worry about searching for data and conducting manual calculations.

In addition, it is a relatively comprehensive metric as it looks at income, expenses, and property price. It gives a good overview of how changing each one of these factors can impact your overall profitability.

Moreover, the cap rate does not measure only ROI but also risk, which is crucially important in real estate investing. You don’t want to risk too much, especially as a beginner.

Last but not least, a good cap rate comes in a well-defined range of 8%-12% (discussed shortly), so investors don’t need to wonder if a certain property is a smart investment or not. All they need to do is to look at the capitalization rate that it offers.

However, just like anything else in real estate, the cap rate is not perfect. It comes with one major drawback.

The Disadvantage of Using the Cap Rate Formula

The main thing investors need to consider about the cap rate is that it doesn’t factor in the method of financing a rental property. Whether you pay in cash or take a mortgage loan does not affect the cap rate. But in reality, how you pay for your investment property significantly impacts your ROI.

It doesn’t mean that you should disregard the capitalization rate metric altogether. Instead, it means that you should use it together with other measures of return, such as the cash flow and the cash on cash return.

Keep in mind that the Mashvisor platform also provides an in-built cash on cash return calculator.

When to Use a Cap Rate in Real Estate

As mentioned, cap rates can be rather useful for real estate investors looking to evaluate the potential value and risks regarding different markets and properties. One of the main benefits of using the cap rate real estate metric is that it combines profit and risk, which other ROI formulas don’t do. Moreover, it’s relatively easier and faster to calculate than other measures.

That’s why it is the perfect preliminary formula to use when taking an initial look at different locations and rental properties for sale within them.

You can decide whether a market offers good opportunities by seeing the average cap rate for short term and long term rentals there. Remember that market-average cap rates tend to be lower than what you can achieve there on well-selected investment properties.

But once you’ve done your initial market and property research and it’s time to deepen your real estate analysis, you cannot rely on the cap rate alone. To make a well-evaluated investment decision, you need to look at complementary metrics like cash flow and cash on cash return.

The best way to do that without running a ton of manual calculations prone to human error is to get access to a real estate investment ROI calculator.

What Is a Good Cap Rate in Real Estate?

A good cap rate is between 8% and 12%.

It’s essential to understand that we cannot talk about a universally good cap rate, but the above range ensures you make enough profit without incurring too high of a risk. As you know based on the definition, the cap rate measures both ROI and risk, So, it’s important to find a good balance between the two to ensure smart real estate investments.

Investors can use the cap rate in real estate to see whether a certain property fits into their own comfort levels. It is particularly important for beginners who don’t own equity in other rental properties to lean on should something go wrong with their first investment property.

It is why it’s crucial not to rush and to instead thoroughly analyze the best cap rate for your investment portfolio. When you have a number in mind that suits your particular circumstances, it will be easy to pick and choose among different properties. In other words, it’s important to have a good cap rate for you personally.

Do You Want a High Cap Rate or Low?

As a savvy real estate investor, you want a cap rate that is well-balanced—one that is neither too high nor too low.

If you go for a too high cap rate real estate investment property, you will take on more risk than needed. Your property will make more NOI, but it will be evaluated at a lower price. If, on the other hand, you opt for a property with a low cap rate, you won’t be making as much money as possible. Furthermore, it will take longer to get your initial investment back.

That’s why investors recommend aiming for 8%-12% of cap rate when buying long term and short term rental properties.

What Does an 8% Cap Rate Mean?

Going back to our example above, an 8% cap rate means that your rental property is able to generate 8% of its purchase price in annual net operating income. 

An 8% cap rate is on the lower limit of the recommended range for good cap rates. It means that a property that is able to offer this level of ROI is a smart investment.

10 Highest Cap Rate Cities for Long Term Rental Properties in 2023

It’s no secret that long term rental properties are one of the best paths to take when easing your way into real estate investing. Essentially, they provide value both in the short term and the long term, namely through rental income and real estate appreciation. Also, it’s always possible to get a professional property manager and start earning a passive income in this way.

In order to secure yourself the best possible deal when investing in real estate, the go-to practice should be to locate the most lucrative locations for your particular strategy. If you’re wondering what the best place to buy rental property in 2023 is, we, at Mashvisor, came up with a top 10 list of cities with the highest long term rental cap rate.

We conduct nationwide real estate and rental data collection in the US residential estate market in order for our algorithms to calculate cap rates by city. We’ve used them to provide you with the 10 highest-ranked cap rate real estate investment locations in terms of the most valuable long term rental opportunities as of October 2022:

1. Vero Beach, FL

• Long Term Rental Cap Rate: 4.37%
• Number of Long Term Rental Listings: 628
• Monthly Long Term Rental Income: $2,618
• Long Term Rental Cash on Cash Return: 4.26%
• Price to Rent Ratio: 23
• Median Property Price: $727,992
• Average Price per Square Foot: $294
• Days on Market: 91
• Walk Score: 78

Start searching for long term rental properties for sale in Vero Beach, FL here.

2. Hallandale Beach, FL

• Long Term Rental Cap Rate: 3.72%
• Number of Long Term Rental Listings: 642
• Monthly Long Term Rental Income: $2,853
• Long Term Rental Cash on Cash Return: 3.61%
• Price to Rent Ratio: 21
• Median Property Price: $728,539
• Average Price per Square Foot: $415
• Days on Market: 92
• Walk Score: 79

3. Stuart, FL

• Long Term Rental Cap Rate: 3.62%
• Number of Long Term Rental Listings: 376
• Monthly Long Term Rental Income: $2,931
• Long Term Rental Cash on Cash Return: 3.57%
• Price to Rent Ratio: 20
• Median Property Price: $719,961
• Average Price per Square Foot: $361
• Days on Market: 68
• Walk Score: 42

4. Fountain Hills, AZ

• Long Term Rental Cap Rate: 3.46%
• Number of Long Term Rental Listings: 122
• Monthly Long Term Rental Income: $3,161
• Long Term Rental Cash on Cash Return: 3.42%
• Price to Rent Ratio: 23
• Median Property Price: $885,044
• Average Price per Square Foot: $359
• Days on Market: 92
• Walk Score: 39

5. Dania Beach, FL

• Long Term Rental Cap Rate: 3.45%
• Number of Long Term Rental Listings: 238
• Monthly Long Term Rental Income: $2,404
• Long Term Rental Cash on Cash Return: 3.37%
• Price to Rent Ratio: 21
• Median Property Price: $609,500
• Average Price per Square Foot: $376
• Days on Market: 63
• Walk Score: 86

6. North Miami, FL

• Long Term Rental Cap Rate: 3.40%
• Number of Long Term Rental Listings: 248
• Monthly Long Term Rental Income: $3,224
• Long Term Rental Cash on Cash Return: 3.31%
• Price to Rent Ratio: 21
• Median Property Price: $829,727
• Average Price per Square Foot: $392
• Days on Market: 31
• Walk Score: 52

7. Williamsburg, VA

• Long Term Rental Cap Rate: 3.31%
• Number of Long Term Rental Listings: 181
• Monthly Long Term Rental Income: $2,139
• Long Term Rental Cash on Cash Return: 3.23%
• Price to Rent Ratio: 22
• Median Property Price: $565,289
• Average Price per Square Foot: $223
• Days on Market: 62
• Walk Score: 81

8. Riviera Beach, FL

• Long Term Rental Cap Rate: 3.30%
• Number of Long Term Rental Listings: 281
• Monthly Long Term Rental Income: $2,686
• Long Term Rental Cash on Cash Return: 3.25%
• Price to Rent Ratio: 25
• Median Property Price: $810,151
• Average Price per Square Foot: $404
• Days on Market: 75
• Walk Score: 43

9. Melbourne, FL

• Long Term Rental Cap Rate: 3.26%
• Number of Long Term Rental Listings: 581
• Monthly Long Term Rental Income: $2,054
• Long Term Rental Cash on Cash Return: 3.18%
• Price to Rent Ratio: 20
• Median Property Price: $496,841
• Average Price per Square Foot: $257
• Days on Market: 64
• Walk Score: 73

10. Punta Gorda, FL

• Long Term Rental Cap Rate: 3.25%
• Number of Long Term Rental Listings: 347
• Monthly Long Term Rental Income: $2,719
• Long Term Rental Cash on Cash Return: 3.21%
• Price to Rent Ratio: 20
• Median Property Price: $655,944
• Average Price per Square Foot: $319
• Days on Market: 100
• Walk Score: 14

Mashvisor can help you search for top-performing long term rentals for sale in the above best locations, as well as any other US residential market. Click here to start your search.

10 Highest Cap Rate Cities for Short Term Rental Properties in 2023

Aside from long term rentals, purchasing Airbnb properties for sale is also a good start to your investment journey in 2023. That said, Mashvisor also prepared a list of the top 10 cities with the highest short term rental cap rate real estate markets, based on October 2022 data.

Note: The following list is based on Mashvisor’s analysis, which is based on data gathered from Airbnb and other primary sources. We did not consider the legalities surrounding short term rentals. The best way to ensure your selected location has favorable laws for non-owner-occupied short term rentals is to check out our short term rental regulations page.

1. Reading, OH

• Short Term Rental Cap Rate: 8.14%
• Number of Short Term Rental Listings: 171
• Monthly Short Term Rental Income: $2,874
• Short Term Rental Cash on Cash Return: 7.85%
• Short Term Rental Daily Rate: $117
• Short Term Rental Occupancy Rate: 53%
• Median Property Price: $225,180
• Average Price per Square Foot: $139
• Days on Market: 40
• Walk Score: 80

Start searching for short term rental properties for sale in Reading, OH here.

2. Schiller Park, IL

• Short Term Rental Cap Rate: 8.10%
• Number of Short Term Rental Listings: 110
• Monthly Short Term Rental Income: $3,853
• Short Term Rental Cash on Cash Return: 7.85%
• Short Term Rental Daily Rate: $155
• Short Term Rental Occupancy Rate: 59%
• Median Property Price: $280,389
• Average Price per Square Foot: $208
• Days on Market: 54
• Walk Score: 71

3. Shaler, PA

• Short Term Rental Cap Rate: 7.98%
• Number of Short Term Rental Listings: 187
• Monthly Short Term Rental Income: $3,304
• Short Term Rental Cash on Cash Return: 7.71%
• Short Term Rental Daily Rate: $156
• Short Term Rental Occupancy Rate: 61%
• Median Property Price: $268,354
• Days on Market: 35
• Walk Score: 24

4. West Saint Paul, MN

• Short Term Rental Cap Rate: 7.86%
• Number of Short Term Rental Listings: 320
• Monthly Short Term Rental Income: $3,367
• Short Term Rental Cash on Cash Return: 7.70%
• Short Term Rental Daily Rate: $151
• Short Term Rental Occupancy Rate: 62%
• Median Property Price: $268,376
• Average Price per Square Foot: $169
• Days on Market: 35
• Walk Score: 75

5. Bellwood, IL

• Short Term Rental Cap Rate: 7.69%
• Number of Short Term Rental Listings: 152
• Monthly Short Term Rental Income: $3,677
• Short Term Rental Cash on Cash Return: 7.45%
• Short Term Rental Daily Rate: $161
• Short Term Rental Occupancy Rate: 64%
• Median Property Price: $257,900
• Average Price per Square Foot: $198
• Days on Market: 54
• Walk Score: 82

6. White Settlement, TX

• Short Term Rental Cap Rate: 7.67%
• Number of Short Term Rental Listings: 166
• Monthly Short Term Rental Income: $3,276
• Short Term Rental Cash on Cash Return: 7.52%
• Short Term Rental Daily Rate: $171
• Short Term Rental Occupancy Rate: 52%
• Median Property Price: $267,032
• Average Price per Square Foot: $188
• Walk Score: 42

7. Richmond Heights, OH

• Short Term Rental Cap Rate: 7.63%
• Number of Short Term Rental Listings: 234
• Monthly Short Term Rental Income: $2,958
• Short Term Rental Cash on Cash Return: 7.45%
• Short Term Rental Daily Rate: $136
• Short Term Rental Occupancy Rate: 51%
• Median Property Price: $229,130
• Average Price per Square Foot: $131
• Days on Market: 108
• Walk Score: 23

8. Northlake, IL

• Short Term Rental Cap Rate: 7.56%
• Number of Short Term Rental Listings: 100
• Monthly Short Term Rental Income: $3,834
• Short Term Rental Cash on Cash Return: 7.35%
• Short Term Rental Daily Rate: $168
• Short Term Rental Occupancy Rate: 57%
• Median Property Price: $304,667
• Average Price per Square Foot: $205
• Days on Market: 66
• Walk Score: 33

9. Sansom Park, TX

• Short Term Rental Cap Rate: 7.44%
• Number of Short Term Rental Listings: 284
• Monthly Short Term Rental Income: $3,176
• Short Term Rental Cash on Cash Return: 7.20%
• Short Term Rental Daily Rate: $165
• Short Term Rental Occupancy Rate: 53%
• Median Property Price: $254,200
• Average Price per Square Foot: $173
• Walk Score: 40

10. Clawson, MI

• Short Term Rental Cap Rate: 7.42%
• Number of Short Term Rental Listings: 298
• Monthly Short Term Rental Income: $3,185
• Short Term Rental Cash on Cash Return: 7.18%
• Short Term Rental Daily Rate: $167
• Short Term Rental Occupancy Rate: 52%
• Median Property Price: $256,732
• Average Price per Square Foot: $219
• Days on Market: 30
• Walk Score: 69

With Mashvisor, you can find lucrative short term rental properties for sale in any of the above locations by clicking here.

Final Words on Cap Rate Real Estate Investments

Long term and short term rental properties are the best real estate investment strategy for the security, ongoing monthly rental income, and long term appreciation that they offer. And the best way to find lucrative investment properties that optimize ROI while minimizing risk is to use the cap rate real estate ROI metric.

Calculating the cap rate of dozens of markets and hundreds of properties for sale may seem impossible. But access to the top cap rate calculator on the market allows you to analyze both locations and listings with ease and efficiency.

Now that you know what cap rate is, why it is important, what affects it, how to calculate it, and what a good range is, all that’s left is to sign up for a 7-day free trial of Mashvisor. 

In this way, you can start looking for short term and long term rentals for sale with a good cap rate across the entire US residential real estate market.