When analyzing the profitability of a real estate investment, return on investment metrics are the go-to pieces of information. There are various types of ROI standards used by real estate investors, including cash flow, cash on cash return, and the topic of this blog, cap rate. What exactly is cap rate? How is it calculated? What is it used for? What is a good cap rate for rental property? Which factors influence cap rate? To learn the answers to these pertinent questions, keep reading!
What Is Cap Rate?
First thing’s first, what is cap rate? Cap rate, which is short for capitalization rate, is a return on investment metric that determines an investment property’s profitability regardless of its financing method. The capitalization rate is expressed as a percentage, with high cap rate investments typically being the most profitable. A good capitalization rate is vital for both traditional rental properties and Airbnb vacation homes.
How to Calculate Cap Rate
Like any return on investment metric, real estate investors need to know how to calculate cap rate. We’ll show you the cap rate formula along with an example.
Cap Rate Formula
The cap rate formula is as follows:
Cap Rate = (NOI ÷ FMV) x 100%
As you can see, the cap rate formula has two main variables.
The first, NOI, stands for net operating income. Net operating income is defined as the difference between an investment property’s annual rental income and its annual rental expenses. A property’s annual rental income is simply its monthly rental income multiplied by 12. Rental expenses, also known as operating expenses, are the sum of all the costs and fees associated with running an investment property. As previously mentioned, the capitalization rate does not take financing into account, and therefore mortgage payments or any other financing costs are not considered rental expenses here. Examples of rental expenses include insurance, repairs, taxes, maintenance, and much more.
The second variable in the cap rate formula is FMV or fair market value. Also known as the current market value in a real estate market analysis, FMV is the value of a property during a certain period of time. In other words, FMV can be the selling price of a property at a certain time.
Cap Rate Calculation Example
Here’s a quick example to put your math skills to the test. A real estate investor owns a rental property that generates $2,000 in monthly rental income and costs $400 to run during that time. If the property’s fair market value is $200,000, what is its cap rate?
Cap Rate = [($2,000 x 12) – ($400 x 12) ÷ $200,000] x 100% = 9.6%
Is 9.6% considered a good cap rate for this investment property? We’ll answer that question soon. But first, you should know that there is an easier way to calculate the cap rate when you are searching for investment properties.
How to Calculate Cap Rate Using a Cap Rate Calculator
Before we discuss what is considered a good cap rate for investment property, let’s talk about how real estate investors can easily find the cap rate of properties without having to calculate them manually. Of course, this is done using a cap rate calculator, which allows investors to learn the ROI of any property they are interested in.
Want to know where you can find a calculator that computes the cap rate for residential real estate properties? Then CLICK HERE, to learn about Mashvisor’s cap rate calculator, a subset of its investment property calculator!
What Is a Good Cap Rate for Rental Property?
So, what is a good cap rate for rental property? Is the 9.6% mentioned in the example above considered an ideal cap rate? Generally speaking, good cap rates for 2020 will range from 8 to 12 percent. However, the range of good cap rate for a residential rental property depends on a variety of factors and different real estate investors will have different answers to this question.
Let’s take a look at the factors that influence cap rate.
Which Factors Influence Cap Rate?
What’s most important when defining the best cap rate for a property is to consider the cap rate range of the location. Other factors, such as real estate investment strategy and property type, also influence the baseline of a good or typical cap rate.
What are the three most important things when buying a rental property? Location, location, and location. This is true when considering the property prices of a rental property investment, and it is also true when analyzing the cap rates of a rental property. Location can drastically affect the average cap rate for rental property. Suburban and rural areas, for instance, tend to have higher cap rates than metro and city areas. There are various reasons why. Urban areas typically have considerably higher property prices than suburban areas. Even with the higher average rental income of urban properties, the result is a lower cap rate than their suburban or rural counterparts.
Real Estate Investment Strategy
Rental strategies are another factor that significantly affects all return on investment metrics, including capitalization rate. Because investment strategies differ in average rental income, they also differ in average cap rate for rental property. Airbnb real estate investing, for example, is generally more profitable than traditional, long-term investing. As a result, Airbnb rental properties typically have higher cap rates than traditional rentals.
Investment Property Type
Much like real estate investment strategies, real estate property types also affect the range of what is considered a good cap rate. Multi-family investment properties generate more income on average than single-family homes. The cap rates of multi-family rental properties are therefore higher than those of single-family rentals.
All in all, the cap rate is an important return on investment metric for real estate investors. Understanding how to calculate it, what is considered a good cap rate, and what factors influence the standard of ‘good’ will help investors on their journey to find the most profitable rental properties.
Are you interested in computing your properties’ cap rates or the cap rates of properties you are interested in? Then CLICK HERE to start your 14-day free trial with Mashvisor!