Are you a beginner or experienced real estate investor? Why do you invest in real estate? It must be the goal to make money with real estate investment properties, right? That’s the goal of every real estate investor. One of the most popular real estate investment strategies is to make money by buying, owning, managing, and renting out investment properties. How much money you make from your rental properties as a real estate investor depends on their return on investment. But how do you measure return on investment in real estate investing? One of the most popular metrics of return on investment for rental properties is the capitalization rate, or cap rate for short. To know how much money you will make as a beginner or experienced real estate investor and what your return on investment will be, you have to know the answer to the question: “What’s a good cap rate for real estate investments?”. Let’s have a look at this important real estate investing metric.
What’s a Cap Rate?
First things first though. Before we answer the question “What’s a good cap rate for real estate investments?”, we have to know the answer to another more basic question: What’s a cap rate?”. Capitalization rate, or cap rate, is one of the most widely used metrics to measure the profitability of a real estate investment property. It measures the rate of return on investment of a rental property regardless of the method of financing. Now, pay attention to this phrase: “regardless of the method of financing”. This is what differentiates cap rate from another important profitability metric in real estate investing – cash on cash return. The cash on cash return metric, unlike the capitalization rate, takes the method of financing – all cash or mortgage – into consideration when calculating the return on investment of a rental property.
Coming back to the nature of cap rates before answering our main question “What’s a good cap rate for real estate investments?”, we can sum up that cap rates are a measure of the level of risk associated with an investment property. Generally speaking, low cap rates correspond to low level of risk, while high cap rates correspond to high level of risk. Anyone who has studied finance will already know that because in investing of any sort, including real estate properties, low risk yields low profitability, and high risk yields high profitability.
How to Calculate Cap Rate?
Now we are a bit more prepared to address our main question “What’s a good cap rate for real estate investments?”, but we still need to know how to calculate cap rate. There is a pretty simple mathematical formula which any beginner or experienced real estate investor can use to calculate this metric of return on investment for rental properties. The cap rates are the annual net operating income (NOI) of the investment property divided by the property price.
Cap Rate = NOI/Property Price
To calculate the annual net operating income, or NOI, of your rental property, you have to multiply the monthly rental income by 12 and subtract from it any rental expenses such as property tax, property insurance, management costs, utility costs, maintenance costs, etc. Since the formula to calculate the cap rate assumes all cash method of financing, don’t worry about the finance costs.
The property price, on the other hand, is the purchase price of your investment property in addition to any other costs related to buying the rental property such as the real estate agent’s fees, the brokerage fees, the closing costs, the rehab costs to get your real estate investment property in a rentable state, etc.
Because being able to calculate the cap rate is very important when you think about “What’s a good cap rate for real estate investments?”, let’s look at an example as the best way to explain any real estate investing metric, term, and concept.
Imagine you buy rental property which is worth $200,000 with the help of Mashvisor’s property search engine and investment property calculator. You pay another $10,000 to finalize the purchase. You start renting out your investment property to tenants immediately and charge them $1,700 of rent per month. The annual costs of owning, managing, and renting out your rental property add up to $5,000. What’s your capitalization rate for this real estate investment property?
Cap Rate = NOI/Property Price
NOI = Monthly Rental Income x 12 – Annual Operating Costs = $1,700 x 12 – $5,000 = $15,400
Property Price = Property Value + Other Costs = $200,000 + $10,000 = $210,000
Cap Rate = NOI/Property Price = $15,400/$210,000 = 7.3%
Now, as a new or experienced real estate investor, you want to know if 7.3% (the capitalization rate in our example) is a good cap rate or not before buying this particular rental property. So, let’s see what’s a good cap rate for real estate investments.
What’s a Good Cap Rate for Real Estate Investments?
Like most important questions in real estate investing, this one – What’s a good cap rate? – does not have a straightforward answer. What’s a good cap rate depends on a number of factors including:
What’s a Good Cap Rate for Real Estate Investments?: Location
Yes, location is very important in real estate investing, we already know that. But did you know that location – or the local housing market – also determines what’s a good cap for rental properties? A busy urban location (New York, San Francisco, Boston) will have a very different capitalization rate from a rural location (like a small village in Michigan or Texas). The reason is that every local housing market is associated with a different level of risk, which determines what level of profitability is acceptable. While a real estate investor will have no problem renting out an apartment or a condo in Chicago or Seattle, he/she might face high vacancy rates with a farm house in the middle of nowhere in Montana. Thus, this real estate investor will expect different return on investment from his/her rental property in each location. The higher level of risk in a less popular housing market will have to yield higher capitalization rate.
What’s a Good Cap Rate for Real Estate Investments?: Time
The housing market is dynamic, and the property price, the rental income, the level of risk, the return on investment, etc. change all the time. So does profitability in terms of cap rates (and cash on cash return for that sake). So, when thinking about what’s a good cap rate, a beginner or experienced real estate investor should not only look at the location but also the time. The Los Angeles housing market today is a different location and housing market from the Los Angeles housing market tomorrow.
What’s a Good Cap Rate for Real Estate Investments?: Property Type
Another important factor determining what’s a good cap rate in a specific location at a specific time is the property type. Each property type – single family home, multi family property, townhouse, condo, or apartment – has its own good cap rate. That’s again related to the level of risk. With multi family property, you rarely face 100% vacancy rate, which means that the level of risk associated with investing in multi family property is relatively low, and so is the return on investment, or profitability. Alternatively, the cap rates will also be low. On the other hand, with single family home or townhouse or condo or apartment, you can easily have 100% vacancy rate. If you are not able to find a tenant, your vacancy is 100%. Thus, the level of risk is high, and so is the return on investment. So, cap rates associated with this property type would be high.
Still, real estate experts attempt to give a straightforward answer to the question “What’s a good cap rate for real estate investments?”. Most experts agree on a range of 8-12%. However, we have to be realistic. The real estate investing business has grown so much in the US in recent years that such a level of profitability is simply not realistic anymore. Actually, a beginner or experienced real estate investor should consider anything above 5% as a good cap rate.
Data from Mashvisor’s investment property calculator confirms this statement. According to Mashvisor’s investment property calculator, most excellent real estate investment properties would yield capitalization rate of 5% or more. While we are on it, you should start your trial with Mashvisor now to take advantage of the property search engine, the investment property calculator, and the endless real estate knowledge to always buy the best real estate investment properties. The need to perform a real estate market analysis as well as investment property analysis will be eliminated.