Business-minded individuals make investment decisions to make a profit. For this reason, the capitalization rate plays an important role in any investor’s decision-making process, as it is one of the things that will determine the profitability of a venture.
Table of Contents
- What Is Capitalization Rate?
- How to Calculate Capitalization Rate in Real Estate
- 10 Locations with the Best Cap Rates for Investment Property Owners
- The Bottom Line
Let’s take a closer look at what a capitalization rate is and the role it plays in real estate investing.
What Is Capitalization Rate?
Investors go into business with the ultimate goal of making a profit and getting a good return for the money they spend. A capitalization rate real estate, or cap rate, is a metric used to measure the return on investment of an investment property regardless of strategy, whether it’s a rental or BRRRR strategy. Although other metrics can also be used to determine ROI, the cap rate is one of the most used in real estate investing.
Capitalization Rate Definition
Cap rate, by definition, is the return rate of a real estate investment property based on the expected income the said property is expected to generate. Simply put, it determines how much an investor can earn from the property.
Why Is It Important in Real Estate Investing?
A lot of folks are always looking to augment their income and finding ways to generate a passive income source that is financially rewarding but not too time-consuming. Veteran investors and notable millionaires claim that real estate is one of the things that meet both criteria.
The thing is, real estate investments are pretty large-scale and can be quite overwhelming, especially to investors who are just starting out. However, the rewards can be totally worth it, considering the year-round income and cash flow investment properties can generate. It can yield greater returns compared to stocks and bonds. Plus, it’s more stable since it is not correlated to the fluctuations of traditional―usually volatile―markets. It’s just a matter of knowing where to put money to get the best possible ROI.
In real estate, ROI is determined by two key metrics: cash on cash return and cap rate. While the former is used by more investors, the latter is equally important in investing.
The main difference between the two is that cash on cash return represents a property’s potential annual profitability, assuming that it was purchased with all cash. It means that it takes into account the financing method used by the investor to acquire a real estate property. But it’s an entirely different discussion that’s best saved for another day.
On the other hand, the cap rate highlights the relationship between the net operating income (NOI) and the property’s market value.
What Is a Good Cap Rate for Real Estate Investments?
For those who are wondering how to invest in real estate, you need to understand how each investment metric is measured to give you an idea of what the ROI is like. The goal is, after all, to make money and not just break even.
Cap rates are one of two major ROI determiners in any real estate investment. But what exactly is a good capitalization rate? How much should it be for an investment to be considered a success?
Technically, the answer to such questions is it depends on how it is used. For instance, if you’re planning to sell a property, a lower cap rate works best because it indicates that the property value is higher. On the flip side, a higher cap rate is ideal for when you buy a property because it means you will need a lower initial investment.
When Should Investors Use Cap Rates in Real Estate Investing?
There are three advantages to using a cap rate. The first one is probably the most obvious. It is easy to compute since the information needed is readily available. It makes comparing returns on different investment types simpler for investors.
Second, it provides investors with a better insight into the property’s profitability. The resulting percentage already gives them an idea of how much they can earn if they buy the property with cash. Even if a debt was used to purchase the property, the return would be significantly higher than the cap rate.
Third, because of the relationship between risk and return, the cap rate helps investors gauge property risk. It means that the higher the cap rate, the higher the risk, and the lower the property purchase price. On the other hand, lower risk means a lower cap rate, which also means a higher property purchase price.
That being said, investors typically use cap rates to screen deals. For instance, if an investor is looking for a property with an 8% cap rate or higher, any property represented by lower cap rates can be weeded out.
It is also extremely helpful in assessing high-risk properties. A property with a 5% cap rate can be easily compared with one with a 10% cap rate to see which one comes with a higher risk premium in the same neighborhood.
How to Calculate Capitalization Rate in Real Estate
Now let’s take a look at how to compute the capitalization rate.
Capitalization Rate Formula
Computing the cap rate is fairly simple since the data you will need is easily accessible. The important details to know are the net operating income (NOI) and the property asset value. The cap rate is simply the percentage of return when you take the NOI and divide it by the property’s market value (assuming that the full amount is paid in cash).
Cap Rate = Net Operating Income / Property Value
Computing for an Investment Property’s Cap Rate
Let’s say you plan to acquire a property that costs $100,000, inclusive of closing costs and repairs. Then, you take that property and decide to rent it out as a traditional rental for $1,000 a month for one full year. It would bring in a total of $12,000 in annual income. However, you also need to pay for certain recurring expenses that would cost you about $200 monthly or $2,400 for the entire year. It means that your NOI (Total Revenue – Operating Expenses) for that year would be $9,600.
Given all the numbers above, you will end up with a cap rate equation of:
- $12,000 – $2,400 (NOI) / $100,000 (Property Value)
- $9,600 / $100,000 = 0.096
Using the cap rate formula, you will get a value of 0.096 as your cap rate, or a 9.6% return on the cash investment.
The numbers, of course, will differ based on the property type and market it is in, but the principle is the same.
Mashvisor’s Cap Rate Calculator
Since the numbers do change and certain other factors need to be considered for computing the most accurate cap rate, investors turn to investment calculators to help them figure out the math.
Tens of thousands of real estate investors trust Mashvisor’s investment property calculator, helping them not only get the most accurate cap rates but also find suitable investment properties based on their calculations.
One of Mashvisor’s advantages over the competition is that its investment property calculator also comes with a cap rate calculator, which really sweetens the deal for its users. It makes both traditional and Airbnb data analysis swifter and a lot less complicated.
While the cap rate formula may be simple to understand and easy to compute, using Mashvisor’s capitalization rate calculator gives investors an edge since it allows them to also compare cap rates of similar properties in the same neighborhood. It gives users a more accurate insight into the market they’re looking at. The calculator helps investors analyze several rental properties, calculate the relevant metric, and make a well-informed decision about which investment properties best fit their real estate portfolio.
To get access to our real estate investment tools, click here to sign up for a 7-day free trial, followed by 15% off for life.
10 Locations with the Best Cap Rates for Investment Property Owners
Now that we’ve already established the importance of cap rates and how to spot good deals using the metric, investors might be wondering which real estate markets in the US have the best cap rates. We’ve made a list of ten markets with some of the best cap rates today, according to Mashvisor’s massive and highly-accurate database.
Take note, however, that each the real estate market continually evolves and the numbers consistently change. The stats are most likely to change in a few weeks, so it is still best to perform due diligence when looking for the best places to invest in. In light of the said inevitable market changes, Mashvisor regularly updates its database to give investors the most accurate information and data they will need to analyze investment properties.
That being said, here are ten markets today with the best cap rates for both traditional and vacation rentals:
Top Markets with the Best Cap Rates for Traditional Rental Properties
If you’re wondering where the best place to buy rental property is as far as traditional cap rates are concerned, check out the following locations:
1. Camden, NJ
- Median Property Price: $154,375
- Average Price per Square Foot: $120
- Number of Traditional Listings: 160
- Monthly Traditional Rental Income: $1,321
- Traditional Cash on Cash Return: 7.36%
- Traditional Cap Rate: 7.86%
- Price to Rent Ratio: 10 (low)
- Walk Score: 63
2. Chester, PA
- Median Property Price: $141,939
- Average Price per Square Foot: $102
- Number of Traditional Listings: 201
- Monthly Traditional Rental Income: $1,218
- Traditional Cash on Cash Return: 7.00%
- Traditional Cap Rate: 7.44%
- Price to Rent Ratio: 10 (low)
- Walk Score: 66
3. Lantana, FL
- Median Property Price: $322,460
- Average Price per Square Foot: $333
- Number of Traditional Listings: 118
- Monthly Traditional Rental Income: $2,237
- Traditional Cash on Cash Return: 4.77%
- Traditional Cap Rate: 4.92%
- Price to Rent Ratio: 12 (low)
- Walk Score: 65
4. Dearborn Heights, MI
- Median Property Price: $215,617
- Average Price per Square Foot: $165
- Number of Traditional Listings: 250
- Monthly Traditional Rental Income: $1,372
- Traditional Cash on Cash Return: 4.54%
- Traditional Cap Rate: 4.78%
- Price to Rent Ratio: 13 (low)
- Walk Score: 60
5. Odessa, TX
- Median Property Price: $302,945
- Average Price per Square Foot: $147
- Number of Traditional Listings: 419
- Monthly Traditional Rental Income: $1,695
- Traditional Cash on Cash Return: 4.09%
- Traditional Cap Rate: 4.25%
- Price to Rent Ratio: 15 (low)
- Walk Score: 53
Top Markets with the Best Cap Rates for Vacation Rental Properties
For those who are leaning toward short-term rental properties for Airbnb and other similar platforms, the following places are the best Airbnb markets with great cap rates:
1. State College, PA
- Median Property Price: $437,828
- Average Price per Square Foot: $223
- Number of Airbnb Listings: 268
- Monthly Airbnb Rental Income: $5,728
- Airbnb Cash on Cash Return: 8.02%
- Airbnb Cap Rate: 8.22%
- Airbnb Daily Rate: $497
- Airbnb Occupancy Rate: 52%
- Walk Score: 94
2. Sheboygan, WI
- Median Property Price: $202,600
- Average Price per Square Foot: $141
- Number of Airbnb Listings: 127
- Monthly Airbnb Rental Income: $2,592
- Airbnb Cash on Cash Return: 7.48%
- Airbnb Cap Rate: 7.81%
- Airbnb Daily Rate: $315
- Airbnb Occupancy Rate: 45%
- Walk Score: 88
3. Bushkill, PA
- Median Property Price: $331,909
- Average Price per Square Foot: $157
- Number of Airbnb Listings: 105
- Monthly Airbnb Rental Income: $4,131
- Airbnb Cash on Cash Return: 7.57%
- Airbnb Cap Rate: 7.77%
- Airbnb Daily Rate: $323
- Airbnb Occupancy Rate: 50%
- Walk Score: 0
4. Galena, IL
- Median Property Price: $445,852
- Average Price per Square Foot: $229
- Number of Airbnb Listings: 216
- Monthly Airbnb Rental Income: $4,781
- Airbnb Cash on Cash Return: 7.41%
- Airbnb Cap Rate: 7.60%
- Airbnb Daily Rate: $269
- Airbnb Occupancy Rate: 63%
- Walk Score: 76
5. Berkeley Springs, WV
- Median Property Price: $426,810
- Average Price per Square Foot: $202
- Number of Airbnb Listings: 143
- Monthly Airbnb Rental Income: $4,261
- Airbnb Cash on Cash Return: 7.39%
- Airbnb Cap Rate: 7.55%
- Airbnb Daily Rate: $216
- Airbnb Occupancy Rate: 67%
- Walk Score: 5
The Bottom Line
Capitalization rate is an important metric used to determine how profitable an investment property can be. Depending on their goals, it can help investors determine which properties are worth looking into and which ones would be a complete waste of their time. It helps speed up the due diligence process since you can easily take out a lot of other properties that do not meet your criteria.
With the help of a website like Mashvisor and its cap rate calculator, investors will have an easier time making informed decisions in the shortest amount of time. To learn more about how Mashvisor can help you find profitable investment properties, schedule a demo.