When it comes to determining a property’s profitability, most investors use a cap rate. But what is cap rate in investing and how does it work?
Table of Contents
- So, What Is Cap Rate in Real Estate?
- How to Calculate Cap Rate on Rental Property
- What Is a Good Cap Rate in Real Estate?
- Limitations of the Cap Rate
When you first get into real estate investing, the cap rate is the first term you will come across. You’ll often hear other investors say things like, “This rental property has a 7.5% cap rate.” But what does a 7.5% cap rate mean exactly?
Short for capitalization rate, the cap rate is not the easiest concept to grasp. And so, naturally, carrying out a cap rate calculation is often a difficult task.
Luckily, you don’t actually need to go about calculating the cap rate yourself. All you need to do is make sure you have a general idea of what the cap rate is. Be aware also of what information it reveals about the rate of return on a rental property.
In this article, we will talk about important things related to cap rates and how they can affect your investment decisions. We will also discuss the cap rate formula so you can figure out the math on your own, whether you’re in the market for a single-family or multifamily unit.
We will also point you to the best cap rate calculator you can find online today to make the job a lot easier for you. Real estate investing is already as complex as it is, so any tool that will help make the job easier for you is something you should consider looking into.
So, What Is Cap Rate in Real Estate?
One question you’ll often hear from real estate investors is, “What is cap rate?”
What does cap rate actually mean? Cap rate (or capitalization rate) is a term used by real estate investors to measure the expected rate of return on an investment property for sale.
Along with cash on cash return, it is the most commonly used metric by which real estate investments are evaluated. This metric is based on the ratio of the net operating income (NOI) that the rental property is estimated to generate to its fair market value.
Calculating the real estate cap rate is important before deciding to buy property because it helps you do the following:
Compare Different Properties in Your Market
Cap rate is most useful for investors when comparing different properties in a given market.
If there are two properties for sale on the market at completely different prices, it can be difficult to determine which makes for the better investment. Just because one is listed at a lower price doesn’t necessarily make it a better investment.
You will always need to consider how much of your total investment can be recouped by the property based on your strategy. For instance, a multifamily property can be quite profitable as traditional or Airbnb properties, compared to flipping it. Your investment strategy is a major factor in how much your investment property will earn.
It’s important for real estate investors like you to understand how much of a return on investment each property is likely to provide. Comparing two cap rates can help an investor quickly make this determination.
Have an Indicator of Potential Risk
Beyond just a simple math formula, cap rate real estate is best understood as a measure of risk.
Rental properties with higher cap rates are typically located in areas that are developing and, thus, come with more risk. In the same manner, investment properties with lower cap rates are typically located in areas that are more stable (often with greater demand). Thus, they are considered less risky.
It is why cap rates are lower in hot markets like San Francisco. There’s so much demand there that real estate investors are willing to accept lower returns due to the lower perceived risk. It helps drive down the overall cap rate in the market.
How to Calculate Cap Rate on Rental Property
How do you calculate the cap rate of a rental property for sale? What is the cap rate formula?
There are actually a few different methods that are used to calculate the cap rate. But, we are going to focus on the easiest formula that you can use. Based on its definition, the cap rate formula is as follows:
The net operating income (NOI) is the expected annual income that the investment property can generate. And the formula for the net operating income formula is:
Net Operating Income = Annual Gross Rental Income – Annual Operating Expenses – Vacancy Expenses
Let’s take a look at an example of how to calculate the cap rate. Say that you’re evaluating a rental property for sale that is priced at $300,000. Here’s how you’d do the calculations using the formula for cap rate:
Step 1: Find out what the property’s fair market value is. Many real estate investors simply use the price, which, for our example, is $300,000.
Step 2: Calculate the annual gross rental income. It is just the amount of rent you collect from your tenants in a single year. For this rental property, it’s $30,000 per year.
Step 3: Next, find out what the vacancy rate for the rental property would be. Let’s set our vacancy rate to 2%.
Step 4: How much will the operating expenses amount to? If the rental property requires $575 in expenses a month, that’s a total of $6,900 a year.
Step 5: Now, calculate the net operating income. You’ll find that it’s equal to $22,500.
Step 6: Finally, use the cap rate formula real estate now after getting both the NOI and the property value.
Related: What Is a Good Real Estate Cap Rate?
Is There a Better Alternative for Computing an Investment Property’s Cap Rate?
In this example, we’ll get to the conclusion that this rental property has a 7.5% cap rate. You can use the above cap rate formula calculator to compare similar investment properties and determine which one has a better cap rate.
Calculating the cap rate once you own an investment property is relatively easy when you keep records of monthly rental income, recurring operating costs, and vacancy rates. But, calculating the cap rate of a property before you buy it can be difficult, especially when you don’t have property data.
Knowing the cap rate on a potential investment is important, regardless of your preferred property and investment strategy. The type of property can be single family, multifamily, condo, or townhouse. The investment strategy can be a rental, fix-and-flip, or wholesale.
You need to know how to look for important real estate comps for a more realistic and accurate calculation. It means you’ll need to search for and gather the data, organize them in an investment analysis spreadsheet, and then run the numbers manually.
If you’re comparing a number of properties for sale, you’ll need to do it multiple times. Imagine calculating the cap rates of dozens of properties until you find the best one.
Needless to say, the entire process will be very difficult and time-consuming, even if you know how to calculate the cap rate.
Alternatively, instead of running all these numbers to calculate the cap rate by hand, you can use one of the best real estate investment tools for investors that estimates your potential rate of return. This tool is…
Mashvisor’s Real Estate Cap Rate Calculator
Mashvisor’s cap rate calculator offers a more convenient way for real estate investors. It saves you both time and effort when you calculate the cap rate as it provides readily available estimates of the cap rate for any property in the 2023 US housing market. You can analyze properties available on the platform and even add your own subject properties.
Mashvisor will then prepare a rental property analysis that includes all the necessary metrics used in calculating the return on investment. They include the cap rate, potential rental income, operating expenses, cash flow, cash on cash return, and occupancy rate.
The data is accurate as it’s based on existing property values and rental comps in the area. It will give you a more accurate and realistic ROI projection on any subject property located in any neighborhood. Therefore, the cap rate calculator is a must-have tool, especially for beginner investors.
To learn more about how Mashvisor can help you find profitable investment properties, schedule a demo.
What Is a Good Cap Rate in Real Estate?
In theory, an investment property with a higher cap rate is considered to be a better real estate deal. That’s because such a property would be making a lot of money relative to the amount invested in it. On the other hand, a lower cap rate indicates that you’re investing more money into a property that will provide a lower return on investment.
However, there are a few critical things to keep in mind. First, the term “good” is more subjective than it is objective. Thus, the short answer to what is a good cap rate depends on how you’re using the cap rate in real estate. Furthermore, cap rate in real estate has become synonymous with risk.
So to determine what a good cap rate for rental properties is, you first must identify how much risk you’re comfortable exposing yourself to.
Generally speaking, the majority of real estate professionals agree that a good cap rate for an investment property is in the range of 8% to 12%. In other words, this is the perfect balance between the rate of return on a rental property and the level of risk that it brings.
However, not all locations offer this type of investment return by way of cap rates. According to Mashvisor’s October 2022 data, the median traditional cap rate in the US is 2.82% (District of Columbia). On the other hand, the median cap rate for Airbnb properties in the country today is 4.32%.
The current median cap rates for rental properties are a far cry from the ideal cap rate range of 8% to 12%. So, most experts now agree that a 2.00% cap rate can give you a decent profit and generate positive cash flow.
Factors That Affect Capitalization Rates
That being said, there are other factors to take into consideration as they affect cap rates and, therefore, what’s considered a good rate. Let’s take a look at each one of these factors so you can understand them better as a beginner real estate investor.
When analyzing a potential investment property to decide on the right cap rate, there are three factors to look at;
1. Real Estate Market (Marco-Level Economics)
Location is everything in real estate investing, so it makes sense that it affects cap rates. To know what an acceptable cap rate for your property is, you need to know the cap rate for a real estate market.
Each city or market has its own set of underlying economic fundamentals, like the median price, employment rate, job market, etc. They significantly impact risk and, consequently, the formula for cap rates. It is why what’s considered good in one market might be perceived differently in another.
For example, investors will accept a 5% cap rate in the New York real estate market because it’s less risky based on its economic fundamentals. But they won’t consider 5% a good cap rate in a market that they perceive as riskier, like the Memphis real estate market.
2. Neighborhood (Micro-Level Influences)
Capitalization rates also differ by neighborhood within the same city or real estate market. It also goes back to economic fundamentals and also geographic location.
For example, home prices are generally higher the closer the neighborhood is to the downtown area and key infrastructure like mass transit, ports, highways, etc. It is why you’ll see lower cap rates to be the norm in such neighborhoods.
In contrast, you’ll see higher cap rates in a lower-demand area or an up-and-coming neighborhood that is in the process of redevelopment.
You can find out cap rates for neighborhoods in any city in the US using our real estate investment calculator. Our calculator will also provide you with neighborhood data to run a complete neighborhood analysis. It will also help you better understand what does 7.5 cap rate mean in real estate investing.
3. Type of Investment Property
Lastly, cap rates vary across different property types because not all types are created equal when it comes to perceived risk.
For example, multifamily homes have lower cap rates than other types because they come with lower risk. It is true as people always need places to live, even during economic downturns. Commercial and retail properties, on the other hand, can struggle during difficult times.
Also, if you’re investing in a multifamily real estate of four units, for example, you’ll have more than one income stream. So, if one tenant doesn’t pay the rent for a month, it won’t affect your income as much as opposed to single-family rental units. If the same happens to real estate investors of single-family homes, they have a higher risk of negative cash flow.
Limitations of the Cap Rate
As great a metric as the cap rate is, it also has certain limitations.
When you use a cap rate formula for computing an investment property’s profitability, you’re assuming that the property will be bought in an all-cash transaction. Basically, the formula dictates that the property’s potential NOI is divided by the total amount of cash investment used to purchase and improve the property.
It poses a big challenge when it comes to profitability analysis, because not everyone who’s into real estate investing buys properties in cash. In fact, only a smal percentage of real estate investors purchase properties in all-cash transactions. Realistically speaking, not everyone has that much extra money lying around to make an investment.
For this reason, a lot of real estate investors are forced to take out loans and other financing options to buy investment properties. It is why a lot of investors don’t rely solely on the cap rate as a profitability indicator for their investments.
Other Metrics for Evaluating an Investment Property
As an investor, you need to look beyond just the cap rate to see whether a property is worth investing in or not. Here are some other metrics real estate investors look out for to find out if a property is worth buying:
1. Cash on Cash Return
One of the most common metrics real estate investors use to determine a property’s profitability is the cash on cash (CoC) return. It basically works similarly with a cap rate with the only difference being it takes into account financing options for the property purchase.
Simply put, it shows you how much you are earning dollar-for-dollar on your initial out-of-pocket investment. Since it takes into consideration your mortgage and debt service, the cash on cash return formula is as follows:
Cash on Cash Return = Annual Cash Flow (Before Taxes) / Total Amount of Cash Invested
A lot of investors use the CoC return metric instead of a cap rate because, as we already pointed out earlier, not everyone can afford an all-cash transaction. It is why we recommend using cash on cash return to gauge a property’s profitability alongside the cap rate.
Just to be clear, cash on cash return is not the same as return on investment or ROI. A lot of people may use them interchangeably, but they have different meanings.
The ROI calculates the total amount of return on a particular investment. It includes the debt burden. Cash on cash return, on the other hand, measures the return on the total out-of-pocket money invested. It gives you a more accurate analysis of the performance of your investment.
2. Net Operating Income (NOI)
Aside from the cap rate and cash on cash return, another metric that’s worth noting in real estate investing is the net operating income or NOI.
By definition, the net operating income shows you how much money a certain investment property can make after all operating expenses are settled. Simply put, the NOI is the total income of an investment property sans the expenses.
Here is the formula for NOI:
Net Operating Income = Potential Rental Income – Operating Expenses
The rental income includes any money made off of a rental property, including rent and regular fees charged to tenants, like parking or housekeeping fees. Expenses include utilities, maintenance, property taxes, property management fees, legal fees, and HOA fees. They do not include mortgage payments.
3. Cash Flow
By definition, cash flow is simply the amount you have left over after all the expenses have been paid. The cash flow formula looks like this:
Cash Flow = Rental Income – Rental Expenses
If you’re in the market for rental properties, it is something you should also consider looking into. At this point, this is where your due diligence comes in. Each market has its own rental income average, as well as its average cap rate and cash on cash return. Not all markets are created equal.
For this reason, real estate investors who wish to start a rental property business must look at other rental properties in the neighborhood to see what the going rates are. It will allow you to evaluate a subject property properly. You would want your investment to give you a positive cash flow at the end of each month.
Your rental expenses include the following:
- General maintenance
- Garbage disposal
- Property taxes
- Rental property management fees
- Flood insurance
- Vacancy rate
- Capital expenditures
So before you set out to buy a rental property, make sure you understand how the pricing for rent rates goes and set the appropriate price that will give you a positive cash flow.
4. Occupancy and Vacancy Rates
As a rental property investor, you also need to take into consideration your occupancy and vacancy rates. Traditional rental properties have higher occupancy rates compared to vacation rentals for the obvious reason that tenants are bound by a long-term lease. Vacation rentals like an Airbnb property aren’t as lucky.
Occupancy rate is the percentage of the time a property is rented or occupied. On the other hand, the vacancy rate is the amount of time your property is left unoccupied. For example, if your property is occupied for only eight months in a year; then your occupancy rate is 67% and your vacancy rate is 33%.
Why are the above metrics important? Because an unoccupied property will still cost you money for maintenance, utilities, and other operational costs to keep it habitable and tenant-worthy.
Traditional rentals are a good example of this. For landlords to maintain their income, they need to keep their vacancy rates low. They can either enter into a new contract with a current tenant (extending the lease) or look for a new tenant. The latter option is trickier because it means that the transition period between tenants should be kept at a minimum.
Airbnb rentals, on the other hand, have higher vacancy rates because of the nature of their business. Short-term rentals are limited to a certain number of months to remain eligible as a vacation rental. If they book beyond that, they can be considered as entering a long-term contract, which has different legal requirements.
It is why you should always find out about the local rental regulations in the area of your choice, so you don’t get into any legal trouble down the road.
The Bottom Line
The cap rate is an ROI metric that is most valuable when used to compare against similar rental properties for sale. That is, properties with a similar location, of the same type, and which are valued at the same point in time.
Now that you know the cap rate formula and what does 7.5% cap rate mean, there’s one last important note to remember regardless of which property type you choose to invest in.
Any smart real estate investor must thoroughly evaluate the cap rate for the specific property they’re buying to ensure it is “good” for the market. It’s best to avoid buying rental property with a very low cap rate when you can easily find properties for sale with cap rates as high as 7.5%.
Smart investors also know how to use technology to their advantage in finding the best possible deals in any market. This is where real estate website Mashvisor comes in handy. Mashvisor specializes in helping investors locate the right property that fits their needs.
It offers real estate investing tools that allow you to locate properties and analyze them thoroughly to ensure you get accurate ROI projections. With tools like the Property Finder, real estate heatmap, and investment property calculator, investors are assured of finding the best deals in the market of their choice.
Mashvisor’s tool will help you find the best investment properties in the best neighborhoods and cities according to the cap rate and other metrics. To access our tool, click here to start your 7-day free trial with Mashvisor and get a 15% discount after!