Real Estate AnalysisIs a Higher Cap Rate Better for Investing in Rental Properties? by Heba Baker May 13, 2019July 1, 2020 by Heba Baker May 13, 2019July 1, 2020You may have been convinced that, when it comes to cap rate, the higher it is, the better. The matter of the fact is that’s simply not always true. To really understand what we mean by this, we need to first clear up exactly what cap rate is. Then we’ll explain why our answer to “Is a higher cap rate better?” isn’t always yes.What Is Cap Rate in Real Estate Investing?Cap rate, short for capitalization rate, is a return on investment metric. It is a calculation used to determine the profitability of a real estate investment. Simply put, the cap rate for rental property is the net operating income (NOI) of a property in relation to the property’s market value.The cap rate calculation is typically used in the real estate investing industry as one of the ways to estimate the return on investment. I mean why not, the formula is pretty simple right?To calculate the cap rate of a property, you simply divide the net operating income by the property’s value. You’ll end up with a percentage. But what does this number really mean?The cap rate formula can get a bit more complicated in real-life decisions. Just looking at the numbers alone won’t tell you the answer to is a higher cap rate better. Use our digital cap rate calculator to get the numbers and insights you need to make a smart real estate investment. Start out your 14-day free trial with Mashvisor now.Understanding Cap RateIt’s important to remember when making any real estate investment decision that one metric alone is never enough to confidently make a smart decision and sound analysis. The cap rate should be used to help determine if the property is a good real estate investment deal. Instead of solely using it to determine if you should buy an investment property, you should use it as one of a few different evaluation tools. A couple of others we recommend you use are purchase price, cash on cash return, rental income, and occupancy rate.Related: Return on Investment: The Metrics Used in Real Estate InvestingThe cap rate can be used on the level of an individual property evaluation by comparing its net operating income to its value (measuring annual return on investment). It can also be used on the level of an entire market by taking average cap rates for a large group of properties.Related: What Are the Best Multifamily Markets 2019 with High Cap Rate?It’s typically used by long-term real estate investors looking to rent out their investment properties. You should use the cap rate as a way to evaluate a real estate investment. However, the cap rate can also be used once you already own the property and before you put the property on the market to sell it.Buy and hold investors, landlords, and commercial real estate investors will definitely be looking at the cap rate when it comes to any investment. It can be used to evaluate single-family homes, as well as multi-family homes.Is a Higher Cap Rate Better?So from the formula, you may have figured that a higher cap rate translates to either higher NOI or lower purchase price. While upon first glance, both of those things sound great, every real estate investor knows to not just take the number as it is and roll with it. You need to understand why the cap is as high or as low as it is. You might be shocked to find that high cap rate properties for sale aren’t always the best option. It leaves you asking yourself, is a higher cap rate better when investing in rental properties? Here are a couple of reasons why that won’t always be the case.1) It’s an Annual RateCap rate is calculated based on annual returns. This means that if an income property performed well or poorly for one year, it will be reflected in the cap rate calculation. However, this also means that you won’t get an overview of how this investment property performed over several years. This is the important part to take note of. So if this investment property’s performance history has been poor in prior years, but at the time of purchase it had positive returns, this can be a false reflection of the property’s true profitability. Real estate investors, especially beginners, should definitely keep an eye out for mysteriously high cap rates in future investment analyses.Related: What Is a Good Annual Return on Investment on Rental Property?2) There’s a TradeoffRemember how we said cap rate can be calculated for both an individual property and for an entire market? Is a higher cap rate better on the market level? Well, here it depends on how quickly you want to start generating cash flow. You don’t need to always go towards the high-cap areas for profitable investments. If you choose a low-cap area, the pros are that there tend to be higher increases in rental rates over time. In this case, the market naturally allows for increased NOI (rent increases coupled with unchanged expenses). Although you won’t be flipping over a profit immediately, low-cap areas will give you long-term value creation in the asset through NOI increases.Related: 2019 Cap Rates by City: What Real Estate Investors Should Expect3) Assessment of RiskThe cap rate is also known as a measure of an investment’s risk level. As the theory goes, a higher cap rate means a high-risk real estate investment. And vice versa for a lower cap rate (you’re dealing with a low-risk real estate investment). This is the same principle that tells us low returns come with low-risk assets (for example, Treasury bonds).Risk is a big part of any investment analysis; you can’t just look at returns. Investors need to assess the level of risk they’re willing to take on to protect themselves from losing money. It’s important to take a deeper look into how the property’s cap rate was actually derived. For example, a high-cap rate property may not have accounted for the occupancy rate (which can really take a toll on your profits if too high). Or it could be a case of calculating cap rate based on estimated or pro forma numbers. Cap rates, in this case, are usually calculated assuming higher rents and lower expenses. So be careful when looking at cap rates for a property by itself. It’s better to look at actual rents and expenses.To learn all you need to know about the cap rate in real estate investing, watch our video below:Final WordsAfter all this talk about the capitalization rate, how do we sum it all up? Well, the cap rate is one of the very useful metrics investors use to evaluate a real estate investment. And it’s based on the ratio of NOI to market value. What is a good cap rate? Is a higher cap rate better? Is a higher value necessarily a ‘good’ thing? There isn’t really a definitive percentage or answer for those questions that could be universally applied in any situation. In some cases, a high cap rate might be the only way to profit; in others, it may be projecting false pretenses.Either way, to truly understand what the right cap rate for your future or current investments is, take advantage of Mashvisor’s data and insights for smarter investment decisions. To learn more about how we will help you make faster and smarter real estate investment decisions, click here. Start Your Investment Property Search! START FREE TRIAL Cap RateReal Estate Videos 0FacebookTwitterGoogle +PinterestLinkedin Heba BakerHeba is Content Writer at Mashvisor with a BA in Business Administration. Most of all, she enjoys writing about the constantly changing markets in the US real estate industry. If not writing, Heba is exploring and learning. Previous Post 3 Real Estate Skills Beginners Can Hone with This Tool Next Post The Fastest Way to Find Investment Properties for Sale Related Posts 2019 Cap Rates by City: What Real Estate Investors Should Expect How Agents and Investors Can Use Predictive Analytics What Cash on Cash Return for a Rental Property Can You Expect in 2018? How to Use The Net Present Value in Real Estate Investing Calculations? How to Evaluate a Neighborhood Before Investing Gross Rent Multiplier: What Is It? How Should an Investor Use It? 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