Making money in real estate is the ultimate goal of buying a rental property. But how exactly does a successful real estate investor know if he/she is making money? The answer is through return on investment (ROI) metrics. One of the most important real estate investing ROI metrics is known as the capitalization rate, or cap rate for short. In this blog, we’ll discuss what cap rate is, how to calculate it, what is considered good cap rate, and how to choose the best rental properties for cap rate.
What Cap Rate Really Is
Capitalization rate is a real estate investing return on investment metric that compares the net operating income (NOI) of a property to its price or fair market value (FMV). Unlike other ROI metrics, such as cash on cash return, cap rate does not take rental property financing into account. For this reason, the capitalization rate is a reliable standard when comparing potential real estate investments.
How to Calculate Cap Rate
Based on its definition, this is the formula used to calculate capitalization rate:
Capitalization Rate = [NOI (Annual Rental Income – Operating Expenses)/Property Price (or Fair Market Value, FMV)] × 100%
Here’s a quick example of calculating cap rate. If you plan on buying a rental property priced at $600,000 that takes $5,000 to operate, with an estimated annual rental income of $45,000, what is its capitalization rate?
Capitalization Rate = [($45,000 – $5,000)/($600,000)] × 100% = 6.67%
The capitalization rate in this example is 6.67%. Is this considered a good capitalization rate or not?
What Is Considered Good vs. High Cap Rate
The capitalization rate is a metric that tells investors if they’re making money in real estate. Therefore, the higher the cap rate of a property, the more profitable it is. But just how much is good and what would be considered high cap rate?
In a very, very general sense, the best rental properties have a cap rate between 8% to 12%. We should really stress that this range is general, because many different factors impact what is considered good and high capitalization rates.
Related: What’s a good cap rate for investment properties?
Some Factors Impacting Capitalization Rate
When buying a rental property, location is everything. Therefore, there is no surprise that cap rates differ from location to location. Rural areas tend to have different cap rates from metro cities. Generally speaking, you can expect real estate investments in large cities to have lower cap rates than those in mid-sized cities.
Property types also impact the ranges of good and high cap rates. Multi-family real estate investing, for example, usually yields higher capitalization rates than single-family home investing.
Good Cap Rates Revisited
Since the range of good and high cap rates largely depends on location and property type, it’s best to first determine the range of good cap rates in your certain area. Still, on a national level, we can say that a good cap rate is between 5% to 10%. Generally, anything more is considered a high capitalization rate. Once again, what is considered high cap rate will differ from area to area.
How to Choose the Best Rental Properties for High Cap Rate
Here are three guidelines for a successful real estate investor to find properties with high capitalization rates.
Find Areas with High Cap Rates
As mentioned earlier, some areas have higher cap rates than others. Thus, a successful real estate investor should scour for housing markets that have high cap rates. In other words, real estate market analysis must be conducted.
The best way to perform real estate market analysis is to use an investment property calculator. Mashvisor’s investment property calculator allows investor to analyze housing markets in a matter of minutes. When looking for areas with high cap rate, all the investor must do is use Mashvisor’s heatmap. The top markets for high capitalization rate will then be displayed.
Maximize Rental Income and Minimize Operating Expenses
One of the main factors in the capitalization rate calculation is NOI, or net operating income. The best rental properties with high cap rates maximize the rental income, and thus maximize the net operating income is the operating expenses are kept the same.
There should be a balance when attempting to maximize rental income and minimize operating costs of real estate investments. Landlords should not rent a property for much more than it is worth. Tenants avoid any property that asks for unfair amounts of rent. Instead of haphazardly raising rent, increase the value of the property through renovations. Then, the rent price can be upticked reasonably, resulting in an increase in rental income. If an investor is still searching for real estate investments, use Mashvisor’s investment property calculator and investment property analysis to find and analyze properties with high rental income and cap rate.
Related: 5 Creative Ways to Increase Rental Income
The other aspect of maximizing NOI is minimizing operating expenses. Like with rental income, this change should be reasonable and fair. Operating expenses include expenses that keep the property running such as maintenance, taxes, and more. To reduce operating expenses, make sure the property functions well. Also consider renovations that would reduce maintenance.
Invest in Low Risk Real Estate Investments
Another way to ensure high cap rates is to buy low risk real estate investments. Multi-family rental properties, for example, tend to have lower risk than single-family properties. Single-family homes carry more risk because they become completely vacant once the housing unit is unoccupied. Multi-family real estate investing does not have this problem, as these properties contain many housing units. As a result, multi-family properties usually generate more rental income, and thus higher cap rates, than their single-family counterparts.
Related: Single Family Homes vs. Multifamily Homes: Differences & Similarities
To Sum Up, Just Use Mashvisor’s Investment Property Calculator
Here’s one step that combines the three guidelines: Use Mashvisor’s investment property calculator! You can find areas and properties with high cap rate and analyze them with the available investment property analysis. All it takes is a few minutes. For more on investment property analysis and all you need to know for making money in real estate, start your trial with Mashvisor!