What Does 7.5% Cap Rate Mean in Real Estate?

When you first get into real estate investing, cap rate is the first term you will stumble upon. You’ll often hear other investors say things like “this rental property has a 7.5% cap rate”. But what does 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 have to go about calculating cap rate yourself. All you need to do is make sure you have a general idea of what the cap rate is and what information it reveals about the rate of return on a rental property.

So, What Is Cap Rate in Real Estate?

The 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. It’s the most commonly used metric by which real estate investments are evaluated. It’s based on the ratio of the net operating income (NOI) which the rental property is estimated to generate to its fair market value. Calculating real estate cap rate is important before deciding to buy property because this helps you:

#1 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 cheaper price, it doesn’t necessarily make it a better investment. Instead, it’s important to understand how much of a return on investment each property is likely to produce. Comparing two cap rates can help an investor quickly make this determination.

#2 Have an Indicator of Potential Risk

Beyond 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. Likewise, properties with lower cap rates are typically located in areas that are more stable (often with greater demand) and, thus, are less risky. This is why cap rates are lower in hot markets like San Francisco. There’s so much demand here that investors are willing to accept lower returns due to the lower perceived risk. This drives the overall cap rate in the market down.

How to Calculate Cap Rate of Rental Property

So how do you calculate cap rate of a rental property for sale? There are actually a few different methods that are used to calculate cap rate. But, we are going to focus on the most common and easiest formula which you can use. Based on the definition of the capitalization rate, the cap rate formula is as follows:

The net operating income (NOI) is the expected annual income which property will generate. And the net operating income formula is (Annual Gross Rental Income – Annual Operating Expenses – Vacancy Expenses). Let’s take a look at an example of how to calculate cap rate. Say that you’re evaluating a rental property for sale that is priced at $300,000. Here’s how you’d calculate its 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. This 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 now that you have both the NOI and the property value.

In this example, we’ll get to the conclusion that this rental property has a 7.5% cap rate. You can use this simple formula to compare similar investment opportunities and which has a better cap rate. Alternatively, instead of running all these numbers 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

Calculating 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 cap rate of a property before you buy it can be difficult, especially when you don’t have property data. This means you’ll need to search for and gather this data, organize them in an investment analysis spreadsheet, and then run the numbers manually. And if you’re comparing a number of properties for sale, you’ll have to do this multiple times. Imagine having to calculate the cap rates of dozens of properties until you find the best one. Needless to say, this will be very difficult and time-consuming.

The Cap Rate Calculator offers a more convenient way for real estate investors. It saves both time and effort as it provides readily-available estimates of cap rate for any property in the US housing market. You can analyze properties available on the platform and even add your own properties. Mashvisor will then prepare a rental property analysis that includes all the necessary metrics used in calculating the return on investment. These include not just the cap rate, but also the expected rental income, operating expenses, cash flow, cash on cash return, and occupancy rate. This data is accurate as it’s based on property values and rental comps in the area. Therefore, the Cap Rate Calculator is a must-have tool in 2020, especially for beginner investors.

what does 7.5% cap rate mean - cap rate calculator

Mashvisor’s Cap Rate Calculator

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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 into 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 objective. Thus, the short answer to what is a good cap rate depends on how you’re using cap rate in real estate. Furthermore, cap rate in real estate has become synonymous with risk. So to determine a good cap rate for rental properties, you first must identify how much risk you’re comfortable exposing yourself to.

Generally speaking, the majority of real estate professionals have reached an agreement that a good cap rate for an investment property is in the range of 8% – 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, 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.

Factors That Affect Capitalization Rates

When analyzing a potential investment property to decide the right cap rate, there are 3 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. These fundamentals have a huge impact on risk and, as a result, cap rates. This is why what’s considered good in one market might be very low 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.

Check out our 2020 Cap Rates by City: What Real Estate Investors Should Expect

#2 Neighborhood (Micro-Level Influences)

Capitalization rates also differ by neighborhood within the same city or real estate market. This also goes back to economic fundamentals and also geographic location. For example, home prices are generally higher the closer the neighborhood is to downtown and key infrastructure like mass transit, ports, highways, etc. This is why you’ll see lower cap rates to be the norm in these 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. This tool will also provide you with Neighborhood data to run a complete neighborhood analysis!

#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, multi-family homes have lower cap rates than other types because they provide lower risk. This is true as people always need places to live, even during economic downturns. Commercial and retail properties, on the other hand, can struggle during these times. Also, if you’re investing in a multi-family real estate of 4 units, for example, you’ll have more than one income stream. So if one tenant doesn’t pay rent, this wouldn’t affect your income. If this happens to real estate investors of single-family homes, they have a higher risk of negative cash flow.

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 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 super low cap rate when you can easily find properties for sale with cap rates as high as 7.5%.

Mashvisor’s tool will help you find the best investment properties in the best neighborhoods and cities according to the cap rate calculation and other metrics. To access our tool, click here to start your 7-day free trial with Mashvisor and get a 20% discount after!

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