The capitalization rate, or cap rate, illustrates the anticipated rate of return on an income property.
Table of Contents
- What Is Cap Rate in Real Estate?
- Estimating Real Estate Cap Rate
- Cap Rate Usage and Drawbacks
- What Is Considered a Good Cap Rate?
- What Factors Affect the Cap Rate?
- Top 8 Cities With the Highest Traditional Cap Rate
- Top 8 Cities With the Highest Airbnb Cap Rate
- How Can Mashvisor Help?
It may be intimidating to pursue a large-scale purchase, especially for the first time. The issues of what, when, and how to fund your future are critical. Following real estate’s recovery over the last decade, it is now possibly the single best method for entrepreneurs to protect their economic future.
Real estate may provide better and more constant returns than stocks and bonds, from year-round revenue to steady cash flows. Before starting to invest in real estate, analyze your choices to ensure you’re picking the most rational and educated decision. The cap rate is a good starting point when it comes to real estate.
What Is Cap Rate in Real Estate?
The capitalization rate is a term used in real estate development to describe the estimated rate of return on a real estate property. The metric is generated based on the net income that the property is predicted to earn and is represented as a percentage by splitting net operating income by property net assets. It calculates the probable return on an investor’s investment in the real estate industry.
The real estate cap rate is capable of quickly comparing the relative worth of comparable real estate investments. However, it shouldn’t be seen as the main predictor of an investment’s strength since it ignores leverage, the time value, and incoming cash flows from property improvements. There are no set rules for what makes a good or bad cap rate, and it is heavily influenced by the property’s and market’s circumstances.
Estimating Real Estate Cap Rate
The cap rate real estate is the most often used metric for evaluating the profitability of real estate assets. The metric essentially shows a property’s return over a one-year time scale, supposing the property is paid for in cash rather than funded. The capitalization real estate rate represents the fundamental, organic, and unleveraged rate of return on investment.
Formula for Capitalization Rate
There are several methods for calculating the capitalization rate. The cap rate of property investment is determined using the most common formula by dividing the building’s net operating income (NOI) by the present market value.
If we do it mathematically, the cap rate formula looks like the following:
Net Operating Income / Current Market Value = Cap Rate
The net operating income is the (expected) yearly income earned by the property (such as rentals) after deducting all expenditures required for property management. The expenditures include the cost of routine facility maintenance, as well as real estate taxes.
The investment’s current market price is the property’s current market value based on current market rates. The number is calculated using the property’s initial capital or purchase cost in another form.
Net Operating Income / Purchase Cost = Cap Rate
On the other hand, the second method is not particularly popular for two main reasons. Primarily, it produces false results for old homes acquired at low prices many years ago. Then, it cannot be used for inherited properties because their total cost is zero, making division unfeasible.
Because property values change so much, the first real estate cap rate formula, which utilizes the current market price, is a more realistic picture than the second, which employs the set value initial purchase price.
Capitalization Rate Examples
Assume you want to buy a multi-family apartment to use as a rental property. Property A is situated in the center, while Property B is located on the city’s edge. You predict that Property A will make $30,000 in rent each year, but you’ll need to pay $8,000 in real estate taxes and maintenance, leaving you with a net income of $22,000. Because the current property value is $300,000, your cap rate would be 7.3%.
($22,000 / $300,000) x 100% = 7.3%
On the other side, Property B generates a $40,000 net operating income and comes with a $200,000 current market value. Your cap rate on the asset would be 20%.
Higher real estate cap rates appear to be better in theory because they represent higher rates of return, but buying a property on the edge of town with little demand may go wrong. Examining things other than cap rates is critical when evaluating investment options.
Cap Rate Usage and Drawbacks
Investors use the capitalization rate to determine an asset’s future return on investment or profitability. When investing in real estate, you want to maximize your chances of profit while remaining within your safety zone.
Real estate cap rate can assist you in deciding between marketplaces, property types, and other investment alternatives. For example, to estimate possible profit, compare a property’s cap rate to the yearly interest rate on government-issued T-bills.
These two investment options, though, are not fully comparable. T-bills provide a security measure by guaranteeing a set return if held until maturity. There are risks in investment property, which can be influenced by the property’s selling value, the real estate market, vacancies or bad tenants, or negative cash flow.
Property investments are risky since cap rates are based solely on predicted net income and shifting market values.
What Is Considered a Good Cap Rate?
Cap rates are set by expected future revenue, which can be unstable and change drastically. A good cap rate for rental property is determined by what you want to earn from an asset and how much you are ready to risk.
A higher cap rate suggests greater risk, whereas a lower cap rate implies lower risk. The real estate cap rate also shows an inverse connection with the property’s value. A greater cap rate is associated with a more costly property, whereas a lower cap rate is associated with a less expensive home.
What Factors Affect the Cap Rate?
Before using a cap rate to buy investment properties, it’s critical to understand the elements that influence the rate. Inability to do so may result in a poor – and expensive – business choice. Here are the three most essential aspects that affect the capitalization rate.
1. Property Type
According to B&B Associates LLP, there are six categories of property: industrial, residential, commercial, industrial, mixed-use, agricultural, and special purpose, which are further subdivided by property features.
Commercial property, for example, contains, among other things, workspaces, retail malls, and hotels. The risks, expenditures, and possible returns are determined by the type of property, which influences the cap rate.
2. Property Value
The real estate cap rate for real estate assets varies depending on how they tie into the marketplace. On a nationwide basis, city real estate often provides higher cap rates than comparable properties in smaller places or villages.
Because metropolitan economies are more diversified, lively, and stable, such investment possibilities are less problematic than their rural equivalents. However, that’s not always the case.
Consider a large city apartment block. The complex would be expensive, but the potential profits would be greater because major cities attract new tenants. With less danger, one would expect a lower cap rate by city than if it were in a less heavily visited state area.
On a more local scale, comparable properties in the neighborhood are heavily influenced by cap rates. A village’s or city’s assets are classified into three types: Class A, Class B, and Class C.
The classification system was designed by investors, borrowers, and brokers to better efficiently and safely explain the quality of a property. For example, Class A facilities are the best in terms of location and health. Class A buildings come with a lower cap rate since they are more valuable.
3. Rental Potential
The characteristics and condition of a property influence its total value and how appealing it is to potential renters. Without renters, property investment will provide little to no cash, perhaps making it a financial burden rather than a source of revenue.
In addition to features and conditions, rental potential considers numerous aspects, such as the supply and demand for real estate in the region and the stability of the rental agreement. All the said variables influence a property’s leasing possibilities and, as a result, the cap rate.
Now that we’ve covered everything there is about real estate cap rate, let’s see the best place to buy rental property considering the cap rate.
Top 8 Cities With the Highest Traditional Cap Rate
Let’s take a look at some of the cities in the United States with the highest cap rates for traditional rental homes. The list is based on Mashvisor’s most recent cap rate statistics per city.
- Greenwood, MS: 10.18 %
- Spruce Pine, NC: 9.98%
- Suwannee, FL: 9.97%
- Presidio, TX: 9.79%
- Saxonburg, PA: 9.67%
- Alturas, CA: 9.14%
- Sylacauga, AL: 8.98%
- Waterville Valley, NH: 8.70%
Top 8 Cities With the Highest Airbnb Cap Rate
Let’s take a look at a few of the US cities with the highest cap rates for Airbnb rental houses. The following list is based on the most recent cap rate data per city from Mashvisor.
- Jennings, LA: 9.95%
- Dunmore, PA: 9.74%
- Marmora, NJ: 9.55%
- Wolverine Lake, MI: 9.12%
- Matamoras, PA: 9.11%
- Horn Lake, MS: 9.08%
- Centerville, OH: 9.03%
- Centereach, NY: 8.99%
How Can Mashvisor Help?
Since that real estate investment requires a significant amount of research and analysis, where should investors look for the most reliable data and the most effective data analysis tools? How to invest in real estate? Let’s see how our tool can help.
Mashvisor is an online real estate platform that aims to make real estate investment easier by offering investors the most up-to-date data from a variety of markets around the US. It also includes a number of valuable real estate investing tools to assist users in finding investment properties and doing Airbnb investment research. Among its most important tools are:
- Property Finder: All you need to do is enter the place you’re interested in (city, area, or zip code) in the search field, and you’ll be presented with a list of available homes on the MLS.
- Real Estate Heatmap: The heatmap tool provides investors with a more accurate picture of market conditions at the local level. It’s color-coded to show whether neighborhoods are the best performing, poorly performing, or somewhere in between.
- Rental Property Calculator: One of Mashvisor’s strengths is that our investment property calculator is more than a calculator. It also enables customers to find the best properties, study the data, and decide on the best investment plan.
Mashvisor is an excellent tool for locating the ideal investment property that aligns with the aims of each investor. Find information about our product here.
Since every investor’s situations are unique, a positive cap rate should not be the only factor to consider. Before making an investment choice, there are a plethora of other factors to take into consideration. For example, your cash flow vision on a particular property may be substantially different from that of another investor on the same asset. What is a successful property for one investor may be the opposite for another.
A real estate cap rate can be useful in determining the potential of a real estate investment. Still, its scope is limited, because they only take into consideration two factors—the property’s net operating income and the estate’s current market value.
Remember that cap rates are estimations, not guarantees, and they are prone to change. You should think of this rate as a guideline on how, when, and where to invest in property rather than as a guarantee of economic success when using it in your business life.
To get access to our real estate investment tools, click here to sign up for a 7-day free trial of Mashvisor today, followed by 15% off for life.