What’s a good cap rate for investment properties?

A cap rate for an investment property is one of the most important tools in the world of real estate investing. And like most widespread questions that bother the minds of many people, it is a complicated one with no single, straightforward answer.

What is cap rate?

To begin with, let’s define cap rate. Capitalization rate is one of the most commonly used metrics to measure the profitability of a real estate investment. It describes the rate of return of a rental property regardless of the method of financing. In theory, cap rates are a measurement of the level of risk associated with an investment property. A lower cap rate corresponds to a lower level of risk, whereas a higher cap rate means a higher level of risk. This is logical as investing in low risk is associated with low profitability, while high risk is related to the possibility for big gains.

Note: Click Here to find properties with readily calculated Cap Rates!

So, how do we calculate the cap rate?

The formula is simple: you divide the net operating income (NOI) by the property price (or value).

Cap Rate = NOI/Price

Related: Investment Property Calculator For Analyzing Real Estate Investments

NOI: To calculate the NOI, you need to start with the annual rental income from an investment property and subtract from it all costs associated with operating the property, including taxes, insurance, management costs, utilities, maintenance, and others. The basic cap rate formula, as we show above, assumes that acquisitions are all paid for in cash and do not involve finance costs. If you, however, are financing a purchase (through a bank loan, let’s say), you will need to include the annual cost of financing your property as an operating expense.

Price: The price is the price that you pay for the rental property in addition to all other acquisition costs such as brokerage fee, closing costs, rehab costs, etc.

Example:

Let’s say it costs you a total of $170,000 to buy a rental property. You can rent it out for $1,500 per month. All annual costs related to your property add up to $3,000. To calculate the cap rate:

Cap Rate = NOI/Price

NOI = annual rental income – annual operating costs = 12 x $1,500 – $3,000 = $15,000

Price = $170,000

Cap Rate = $15,000/$170,000 = 8.82%

Now that we’ve gone over the calculations, let’s go back to our initial question: what’s a good cap rate for an investment property. There is no unanimous answer to this question. However, most experts tend to agree that the value of a cap rate should be around 10%. For most rental properties around the U.S., the value is between 8% and 12%.

What is an acceptable cap rate for my property?

First, the cap rate varies based on the asset type. For instance, multifamily properties consistently have the lowest cap rate because they are considered to provide among the lowest risk. The reason is simple. Apartment buildings generate their rental income from numerous tenants every month. So even if one or two of your tenants don’t pay their rent for a certain month, the change in your cash flow for that month relatively small. Conversely, imagine a large, luxurious house that you out to a single family. If the tenants don’t pay their rent for this month, you’re left with no income. The risk is high.

Second, the cap rate is different in different markets. As you’ve heard many times, in real estate investing location is everything. States, cities, and neighborhoods all have different cap rates. This is partially because rents, operating costs, and acquisition costs change from one place to another. They also change over time. Different markets also exhibit different supply and demand, which will also cause significant differences. So while you can use cap rate to compare the risk and the profitability of comparable properties in the same market, you shouldn’t decide between buying a small apartment in Boston or a two-story house in Miami solely based on it. As a general rule, set the average cap rate in the area that you are considering as your minimum goal when purchasing an investment property.

Note: Click Here to find the best performing Cap Rate properties in the US!

Related: How To Do Investment Property Analysis

To sum up

In conclusion, the capitalization rate is a helpful metric to use when shopping for a market and for a property. However, you should not base your final decision regarding your property purchase entirely on cap rate. A major disadvantage of the cap rate is that it doesn’t take into consideration the depreciation/appreciation of a rental property, which plays a major role in determining the return on your real estate investment. Also, it does not account for the way of financing your property. Importantly, the cap rates may be misleading in growing markets. For example, even if the cap rate is not great at the moment, it might be worth it if you invested in a property in a market that is set to grow. This gives you the opportunity to enjoy higher rents and a significant appreciation of your property in a few years.

Finally, when browsing for an investment property, use Mashvisor to filter listed properties by capitalization rate, as well as cash on cash return and rental income. Ultimately, Mashvisor helps you find properties throughout the U.S. which meet your requirements and needs as a real estate investor.