Everyone in real estate is searching for the best places to invest, and one of the key factors is knowing how to find cap rate for a market.
Investors want to be certain they will have a strong return on the money they put into a rental property. The first step in this process is finding a location with profitable opportunities which means an area that brings good cap rates.
Table of Contents
- What Is Market Cap Rate?
- How to Calculate Market Cap Rate: The Formula
- How to Find Cap Rate for a Market and a Property: The Best Way
While the cap rate is such a crucial metric in the rental property investing business, some investors are unsure about its meaning and calculation. Here, we’ll provide you with all the knowledge you need to make excellent investment decisions using the cap rate concept. We’ll start with what it means, go through how to calculate it and end with the best tools for optimizing your investments.
Let’s get started!
What Is Market Cap Rate?
Before knowing how to find the cap rate of an area, it’s important to understand what stands behind this term. It is a pretty popular metric used among real estate investors to analyze the return on a real estate investment.
The cap rate measures the ROI of a rental property relative to the market value of the property rather than the invested amount. In this way, investors know exactly how much money they can make compared to how much their rental is worth.
While commercial real estate cap rate values are more frequently seen, residential real estate investors love to use this metric, too,s because of its simplicity over other ROI measures.
Moreover, the cap rate has another significance. It is also used to evaluate the risks associated with buying a certain income property. After all, more risky endeavors tend to bring higher profits and vice versa.
Why Is the Cap Rate So Important?
The importance of the capitalization rate concept is based on a few different factors.
First of all, it offers a very straightforward way to calculate the profitability of both an entire market and an individual property. As we’ll see in a bit, the cap rate formula is significantly easier than the calculations of other real estate return metrics.
Second, the cap rate allows investors to easily compare the ROI of multiple markets and properties for sale. You know that areas with a higher cap rate will bring more profit; it’s as simple as that.
Third, since the cap rate estimates risk too, it helps investors ensure that they invest within their comfortable level of risk. Each person is willing to tolerate a different amount of risk, and this metric allows you to stay within your own.
Last but not least, after buying an investment property, landlords and Airbnb hosts can use the cap rate to check if their rental performs as expected. If your cap rate is below the market average, this means that there’s something wrong with the management of your property, and you’re leaving money on the table. You can use this as an indicator to boost your property management strategy.
What Are the Pros and Cons of Using Cap Rate in Real Estate Investing?
Just like all other ROI metrics, the cap rate has its own advantages and disadvantages. Before making use of it in your investment decisions, you should understand both.
The main pros of the cap rate formula include the following:
- Easy way to estimate the return on investment
- Opportunity to compare markets and listings
- Ability to calculate risk
Meanwhile, the major cons of this metric are:
- No consideration of the invested amount
- Access to reliable real estate data needed
- Time-consuming calculations when evaluating numerous markets and properties
All this means is that the cap rate is a great aspect to include in your rental market analysis and rental property analysis. However, it’s not enough to look at just the cap rate. For a comprehensive evaluation of a real estate investment opportunity, you should include other metrics as well.
What Factors Affect the Market Cap Rate Calculation?
Part of learning how to find market cap rate is understanding what factors impact its results.
There are a few different things that affect the average cap rate by zip code or city, and they include:
- Property values: Areas with more expensive home prices generate lower ROI.
- Rental rates: The more money you collect from your tenants or guests, the more profit you get.
- Demand for short and long term rentals: Strong rental demand translates into good Airbnb occupancy rates, which lead to higher returns.
- Supply of rental listings: An oversaturated rental market cannot bring high profitability for investors.
- Rental expenses, including utilities and property management fees: How much money you need to spend on your rental business determines how much you make from it.
- Accessibility: Markets with good transportation options attract more renters and suffer from fewer vacancies, pushing up overall profitability.
- Availability of amenities and attractions: You want to invest in a neighborhood with a lot to offer to renters in order to attract them to your property.
When searching for the best long or short term rental markets with high cap rates, it’s important to focus on all these factors.
What Is the Difference Between Cap Rate and Cash on Cash Return?
While the capitalization rate is an indispensable part of the investment property analysis, it does not suffice to guarantee a high return. Investors need to take into consideration other metrics as well, and one of these measures is the cash on cash return.
Beginner investors frequently confuse the cap rate and the cash on cash return as measures of profitability. It’s true that there are some similarities between the two, but the differences are much more significant.
The main difference between the cash on cash return and the cap rate by zip code is that the former looks at an area’s ROI relative to total cash investments and the latter – relative to purchase prices.
In other words, the cash on cash return considers the method of financing a rental property as it looks at how much money you have put down. The cap rate ignores whether you buy in cash or with a loan and looks at the market value of the property instead.
What Is a Good Cap Rate?
Lastly, before getting into how to find cap rate of an area, let’s go over what a good cap rate is and what a bad cap rate is.
According to real estate experts and experienced investors, a good cap rate for a property is between 8% and 12%. A bad cap rate is anything below or above this range. Less than 8% means you will not make enough money, while above 12% signifies too much risk involved in the investment.
When we look at the cap rate of markets, though, things are different. Mashvisor nationwide market analysis shows that values above 6% are rarely seen on the city level because they represent the performance of all rental properties. Usually, a market cap rate of 4-5% is considered good, indicating strong potential in the area.
How to Calculate Market Cap Rate: The Formula
Learning how to determine cap rate in an area boils down to knowing the formula and how to use it.
The cap rate formula is:
Cap Rate = Net Operating Income (NOI) / Purchase Price x 100%
This is the formula to calculate the ROI of a specific rental property. Estimating the cap rate of an entire market requires calculating the average value of all short or long term rentals available there.
The property’s net operating income refers to the amount left after subtracting all expenses necessary to operate a rental property business from the total rental income. The cap rate formula looks at the annual net operating income, not the monthly value.
The purchase price, on the other hand, is the sales price of the property. In some cases, it is replaced with the current market value of the rental, especially for properties bought many years ago.
As you can see, the calculation does not take into account the financing method, only the worth of the investment property. That’s what makes the cap rate particularly applicable to markets as well as properties. And that’s what makes it relatively easy to calculate.
But this omission is also the main reason why you have to include other metrics too in your rental property analysis. At the end of the day, how much you pay for a property and over what period affects your return on investment.
Cap Rate Example
In order to better understand how to find local cap rates, let’s have a look at a specific example. Imagine you buy an investment property to rent out on a long term basis. The purchase price is $350,000. You then rent it out for $3,000 per month. Each month, you spend an average of $500 on managing and maintaining the property.
What is the cap rate for this property?
- Net Operating Income = 12 x $3,000 – 12 x $500 = $30,000
- Purchase Price = $350,000
- Cap Rate = $30,000 / $350,000 x 100% = 8.57%
So, this rental property has a cap rate of 8.57%, which is considered good.
How to Find Cap Rate for a Market and a Property: The Best Way
Now that we’ve covered individual property cap rates in detail, let’s dive deeper into how to find local cap rates for entire markets.
In theory, you should be able to calculate the market-level cap rate by finding the average value for multiple–if not all–properties there. However, this will require access to tons of long or short term rental data, which can be expensive. Moreover, you have to do a lot of calculations. In other words, this is mission impossible for a beginner investor with no previous experience.
Luckily, there’s another, much more efficient way to answer the question, “What is the cap rate in my area?”
With the help of the Mashvisor real estate investment tools, of course. Our analytics platform can provide accurate cap rate data on cities, neighborhoods, and properties.
Here is how:
How to Find Cap Rates by City
The first step in evaluating the profitability of a market is to analyze the city. Depending on your rental strategy, you need to locate a city or town that has the required attributes, which will result in a good ROI.
Mashvisor collects data on both short and long term rental properties across the nation. With nationwide listings in our database, we can accurately calculate the average cap rate in any US market.
All you have to do to get access to this data is to visit our real estate investing blog. We publish regular updates on the most popular investment locations as well as rankings of the best markets for buying a rental property. You can check out the Top Locations section of our blog.
How to Find Cap Rates by Neighborhood
After locating a city with a good cap rate, the next step is to find the most profitable area within this city in order to conduct a comprehensive market analysis. The reason is that return on real estate investments can vary widely from one neighborhood to another because of property prices, rental rates, types of tenants, amenities, etc.
Mashvisor has a tool that can help with neighborhood analysis. The Market Finder allows investors to search for the best areas for buying a long or short term rental in any US city. Investors can choose from many different filters, including home values, rental income, and – of course – cap rate.
Once you enter your criteria, the tool will provide you with the top 10 neighborhoods that meet your expectations. For each of them, you can see the average cap rate for your preferred rental strategy.
How to Find Cap Rates by Property
Finally, a good investment decision culminates in identifying a listing for sale with strong potential. Not all properties can become money-making opportunities, even in the best city and the best neighborhood.
The Mashvisor investment property search engine can help you find MLS listings that promise a high cap rate. All you need to do is enter your search criteria, including market, budget, rental income, cap rate, and others. Immediately, you’ll be given a list of the investment properties for sale that meet your expectations.
With the help of the Mashvisor cap rate calculator, you can see exactly what cap rate each of these properties will bring when rented out both on a short and long term basis. Moreover, you can use the calculator to analyze the expected performance of any off-market property, even if it’s not listed on the Mashvisor platform.
To identify the best markets and properties for investing in real estate, sign up for a 7-day free trial of Mashvisor.
Investing in Locations and Properties With Good Cap Rate: Final Words
Knowing how to find cap rate for a real estate market as well as a property is a must in the rental property investing business. It is the only way to ensure a high return on investment which is the ultimate goal of every investor.
At the same time, getting the necessary data and making the required calculations to compute a market cap rate can take weeks, if not months. And investors simply don’t have this time if they don’t want to lose the deal to another investor who’s more knowledgeable in the area.
The solution to this dilemma in real estate investing is using the Mashvisor tools. On our platform, you can search for markets and properties with good cap rates in addition to calculating the expected ROI of neighborhoods and houses.
To learn more about how Mashvisor can help you find real estate deals with a good cap rate, schedule a demo with our team of experts.