Investing in a rental property could be one of the best decisions you make! When renting out, you might find yourself asking: What is a good cap rate?
We usually associate the term ‘cap rate’ with searching for an investment property. For example, when you’re on the hunt for a new real estate investment, you find yourself looking at cap rates, as you should. It’s a very important real estate metric that can tell you a lot about an income property. But, what about after you’ve purchased the investment property? What happens to the cap rate then? What is a good cap throughout the operational period of this investment? There are a lot of things to consider before finding the answer to these questions. Let’s first give a quick run-through of what a cap rate is and what its significance is when renting out.
Searching for an investment property? Read: Best Cities for Buying a Rental Property in 2018
What Is a Cap Rate?
It’s short for capitalization rate. It’s a metric of the return on investment analysis done on a rental property. The cap rate basically is a measure of the profitability of this investment. By comparing the net operating income with the property’s price, we get cap rate.
Cap Rate= Net Operating Income / Property Price
- Net Operating Income: Finding the NOI consists of two factors: the rental income and the rental expenses. You start off with the annual rental income generated by this investment property (the rent collected from tenants). Then, you begin to subtract all the operating expenses of this rental property: property taxes, maintenance, utilities, repairs, property management, and any other cost associated with operating the property.
Note: If your financing method for the property is to take out a mortgage, you wouldn’t include this as an operating expense.
- Property Price: This is the cost of purchasing the property. If the property price isn’t listed, don’t worry. You can search for similar investment properties under similar circumstances (in the same location) to get the property’s relative market value.
We only provided you with the cap rate formula to give you a clear idea of it. Most successful real estate investors know better than to spend hours on manually calculating real estate metrics like the cap rate, cash flow, cash on cash return, and more. To quickly and easily find the best investment properties, use a rental property calculator. This is a digital tool that makes the process of conducting an investment property analysis and analyzing the profitability of an investment much easier. Find the best rental property calculator at Mashvisor which is guaranteed to let you know what is a good cap. For more on this amazing real estate investment tool, click here.
What Is the Significance of Cap Rate?
When we’re looking for what is a good cap rate, we’re searching for much more than just a metric of investment return for a single property. Cap rate has a lot more relevance in the real estate market. Here’s what we’re talking about:
- The cap rate doesn’t just estimate the expected return on investments. It also represents the level of risk associated with this investment. A low cap rate implies that this is a low risk real estate investment. Whereas a high cap rate means this is a high risk real estate investment. What is a good cap? Most real estate investors go after investment properties with a high cap rate. If you’re confused at the fact that people are going after more risk, let us explain. Simple financing and accounting tell us that higher risk equals higher returns. So naturally, you can understand that an investment with a high cap rate is an investment expected to have a good return on investment.
- It’s important to note that the cap rate can be used for analyzing a specific investment property, but it has a much bigger impact. It’s a market-driven metric. So when we ask what is a good cap rate, we’re asking in relation to the overall real estate market we’re in. The cap rate takes into consideration the behavior of all the market participants. This is connected to what we mentioned above about property price. We said, if property price isn’t listed, we can just use rental comps to find it’s market value. In order to estimate the valuation of property, we need to conduct a comparative market analysis (CMA). One of the factors used in this analysis is the cap rate. Similar cap rates can give an indication that these properties have a similar market value. Of course, you can’t just assume a similarity of the investment properties based on just the cap rate, but it’s a good place to start.
Related: How to Do Comparative Market Analysis with a Rental Property Calculator
What Is a Good Cap Rate When Renting Out?
In real estate investing, cash flow is key. Certain metrics, like the cap rate, are an important indicator of a property’s profitability. If you invest in a rental property and take on the role of landlord, you get to witness first-hand the performance of your property. If you’re renting out to many tenants and have managed your property well, you can expect a positive cash flow which translates to a good performance. When searching for what is a good cap rate while you’re renting out, you’d expect to find the text-book 6-8%. However, every real estate market has its own definition of what is a good cap rate. It all depends on the different circumstances in which the market is being evaluated. Generally, a higher cap rate means higher returns.
A good cap rate when renting out is one that allows for a profit to be made. The only variable in the cap rate formula you have control over is the NOI. If you put in efforts to increase rental income, you can achieve profitability. Real estate professionals purchasing rental properties, for example, may buy at a 4% cap rate in high-demand areas, or a 10% cap rate in low-demand areas. In general, 4% to 10% per year is a reasonable range to earn for your investment property.
Let’s assume you’re renting out in a high-demand area, and the market’s cap rate is 4%. If you’ve purchased an investment property for $325,000, the calculation for the necessary NOI to make a profit would be 4% x $325,000= $13,000. This means that after deducting all operating costs from your rental income, you should be receiving $13,000 annually.
Related: What’s a Good Cap Rate For Investment Properties?
The bottom line: what is a good cap rate when renting out? It depends on the real estate market and the property’s performance. Make sure to check out Mashvisor for your next real estate investment! To start looking for and analyzing the best investment properties in your city and neighborhood of choice, click here.
