The only way real estate investors can understand the profitability of their rental properties is through return on investment. Return on investment, also known as ROI, measures the rental income generated by income properties, their prices, and their operating and rental expenses to give the most accurate measure of profitability. There are two main measures of return on investment: cash on cash return and cap rate. We’ve talked about cash on cash return before; be sure to read this blog to learn more about it: “What is a Good Cash on Cash Return?” Now let’s tackle the same question but for cape rate. What is a good cap rate for investment properties?
What is Cap Rate?
Before we answer what is a good cap rate, we need to discuss what cap rate actually is. Cap rate, short for capitalization rate, is a return on investment measurement of rental properties regardless of how they were financed. Capitalization rate is based on the rental income, rental expenses, and value of a rental property. Cap rate also tells real estate investors how much of the property’s value they are receiving in profit. Like other measures of return on investment of rental properties, cap rate is expressed as a percentage. Understanding the cap rate of investment properties is vital when making money in real estate, regardless of rental strategy. Therefore, real estate investors need to know how to calculate it with the cap rate formula, which is what we will now cover.
How to Calculate Cap Rate
Cap Rate Formula
Based on the definition, here is the cap rate formula:
Cap Rate = (Net Operating Income / Current Market Value) x 100%
The cap rate formula consists of two main factors: net operating income (NOI) and current or fair market value (FMV). What do these factors mean?
NOI is the difference between annual rental income and the annual rental expenses of a rental property.
NOI = Annual Rental Income – Annual Rental Expenses
Rental, or operating, expenses are costs associated with running investment properties. These include taxes, insurance, maintenance, repairs, and much more. Financing costs, like mortgage payments, do not classify as operating expenses.
The second factor, FMV, or fair market value simply refers to the value of the investment property at a certain time. Essentially, FMV is the price of the property.
Cap Rate Calculation Example
Let’s test what you’ve learned with a quick example. A real estate investor owns a property that generates $30,000 in annual rent and costs $5,000 to run during that time. If the property’s value is $250,000, what is its cap rate?
Cap Rate = ($30,000 – $5,000) / $250,000 = 0.1 = 10%
The real estate investor will have a property with a cap rate of 10%. One main question remains: is this cap rate good?
What is a Good Cap Rate?
We now can finally answer the focus question of the blog: what is a good cap rate? Generally speaking, the answer is anything from 8% to 12%. Still, the answer to the question is not as straightforward as it might seem. That’s because the range of what is a good cap rate varies based on different factors.
What Factors Impact the Range of Good Cap Rate?
Location impacts everything in real estate such as rent, rental strategy, and financing options. It should come as no surprise that location also affects the answer to “what is a good cap rate?”. For example, what may be considered a good cap rate in a suburban area is actually very little in a metro area.
Rental strategy also changes the range of what is a good cap rate. Airbnb rentals, for example, tend to generate higher rent compared to traditional rentals. Traditional rentals, on average, cost less in rental expenses than Airbnb rentals. Because of these differences, the range of a good cap rate will differ depending on rental strategy. To learn more about the difference (and similarities) between Airbnb rentals and traditional rentals, check out this blog: “Real Estate Investing: Traditional vs. Airbnb Investments”!
Property type also impacts what is a good cap rate. For instance, multifamily rentals generally have higher cap rates than single-family homes. The ranges can also differ with long-term rental properties and short-term rental properties.
It’s clear that narrowing down what is a good cap rate is difficult, due to the many factors to consider. Therefore, the general 8% to 12% range can be reduced to 5% to 10%. Still, what’s most important is to determine the good cap rate range in a certain area. This is perhaps the strongest baseline of what is a good cap rate. Of course, you can compare your property based on the type and rental strategy to others in the location for more accuracy. The best way to do this is to use Mashvisor’s rental property calculator and its property search. Click here to get yourself started with a 14-day free trial!
Why is Cap Rate Important?
Why even bother finding out what is a good cap rate? There are three main reasons.
Return on Investment
As previously mentioned, cap rate is one of the two main forms of ROI. Without cap rate, a real estate investor cannot determine how profitable income properties are.
Compare Investment Properties
Since it’s a form of ROI, cap rate can be used to distinguish between investment properties based on expected profitability. Income properties with higher cap rates will be more profitable than those with lower cap rates. The best real estate investments always have high cap rates.
Estimate Payback Period
Cap rate can also estimate how long it will take to fully cover the property payment. To do this, divide 100 by the cap rate of the property. In the previous example, the payback period of the property is 10 years (100 divided by 10).
Where Can You Calculate Cap Rate?
Now that you know the answers to what is a good cap rate, how to calculate it, and why it is important, you might be left with one question: where can you calculate cap rate? The answer is very simple: right where you are! Mashvisor’s cap rate calculator, a function of its rental property calculator, calculates the cap rates of properties at the click of the mouse. To learn more about our calculator, read this: “Investment Property Calculator for Analyzing Real Estate Investments”! To get yourself started with our services, click here!