Cap rate, also referred to as capitalization rate, is one of the most important real estate metrics used by investors to analyze housing markets and investment properties. If you are looking to buy a profitable rental property in 2021, it’s important that you have an answer to the question “what’s a good cap rate for rental property?” before you invest. But before we dive into that, you should have a good understanding of what “cap rate” means.
What Is Cap Rate?
Capitalization rate (cap rate) is a metric used to measure the rate of return of an investment property by expressing the property’s net operating income as a percentage of its market value. This metric is used to determine what the rate of return will be before debt is taken into account. Therefore, it provides an apples to apples comparison of multiple investment properties.
Here’s the cap rate formula:
Cap Rate = Net Operating Income/Fair Market Value × 100
To calculate net operating income (NOI), you subtract the annual operating expenses (excluding mortgage payments) from the annual rental income. The fair market value is the prevailing price for similar properties in that location.
Now that we know how cap rate is calculated, let’s revisit the question “what’s a good cap rate for rental property in 2021?”
Related: Cap Rate in Real Estate Investing: Everything You Need to Know
What’s a Good Cap Rate for Rental Property?
The answer to this question is a complicated one. There’s no clear-cut value that can be considered a good cap rate. When analyzing a potential investment property, investors need to take a number of variables into account to determine the right cap rate.
The range for what a “good cap rate” is will vary based on a number of factors including:
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Location
Cap rates can vary by location.
First, like for most real estate metrics, the range for what a good cap rate is will vary from location to location. Busy urban locations will typically generate lower cap rates due to the high demand for investment properties (higher property prices) and low associated risks compared to rural locations. Investors are usually willing to pay more for properties in major cities because they perceive them to be less risky due to stronger demand. Generally, the average cap rate for a real estate market should be your minimum goal.
Here is a list of some of the major cities in the US and their average traditional cap rates. The data comes from Mashvisor and will give you an idea of the cap rate you can expect in any of these cities:
- Washington, DC: 2.8%
- Los Angeles, CA: 1.8%
- Houston, TX: 2.9%
- San Diego, CA: 2.0%
- New York, NY: 1.2%
- Detroit, MI: 3.8%
- Chicago, IL: 1.8%
- Atlanta, GA: 2.8%
- Dallas, TX: 2.0%
- Birmingham, AL: 3.7%
- Philadelphia, PA: 3.3%
- Seattle, WA: 1.9%
- St. Louis, MO: 2.6%
- Lincoln, NE: 2.1%
- Stamford, CT: 2.7%
- Omaha, NE: 1.4%
- Miami, FL: 2.3%
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Property Type
Cap rate will also vary depending on the type of investment property. For instance, investment properties associated with low risk like multifamily homes will typically have a low cap rate. They have lower associated risks because they rarely experience a 100% vacancy rate as opposed to single-family homes.
Therefore, when using the cap rate to compare investment properties in a particular market, make sure they are of the same type.
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Timing
The current state of the real estate market will also affect what a good cap rate is. For instance, in a buyer’s market, the cap rates will be higher due to lower property prices. Therefore, a good cap rate for investment properties will typically be higher in a buyer’s market than in a seller’s market.
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Risk Tolerance
As mentioned earlier, cap rate is typically a measure of the real estate investment’s risk level. In general terms, the higher the cap rate, the more risk is associated with the real estate investment.
Since every investor’s risk tolerance is different, some may consider a lower but more stable cap rate a good cap rate. Other investors, especially the most experienced ones with a bigger portfolio, may prefer a higher and riskier cap rate
So What Cap Rate Should You Look for in 2021?
While it’s hard to put a number on what a “good cap rate” is, according to most real estate experts, the value should be between 8% and 12%. This range usually offers the perfect balance between the associated risks and the expected rate of return. The most successful property investors are usually the ones who are willing to do their due diligence and ensure that the potential returns match the risks they are taking on.
Remember, real estate cap rate is a comparative real estate metric and should be used only when assessing similar investment properties for sale. This means that the properties should be located in the same market and be of the same type. Moreover, the investment properties should be analyzed at the same point in time.
If you want to find the best markets to invest in real estate in 2021 based on cap rate, you’ll need to do a thorough real estate market analysis. You can begin your market analysis by looking for cap rates by city on Mashvisor’s real estate blog.
You also need to know how to calculate cap rate to be able to analyze investment properties for sale in your market of choice. If you want to find high cap rate properties for sale in any market in the US, the best way is to conduct a cap rate analysis using Mashvisor’s cap rate calculator.
Calculating cap rate manually can be time-consuming and is also prone to error. However, with our cap rate calculator, you can get accurate cap rate estimates in just a matter of minutes.
The Bottom Line
Cap rate is an important metric for investors who are shopping for profitable markets and investment properties. However, one of the questions commonly asked by beginner real estate investors is: what’s a good cap rate? The truth is that what constitutes a good cap rate is not cut and dry. You have to consider several factors including location, property type, and the timing of the investment.
Keep in mind that you shouldn’t base your investment decision on the cap rate alone since it’s not a perfect measure of real estate return on investment. For instance, it doesn’t take into account the financing method as well as the appreciation or depreciation of the property. This means that you should also consider other metrics such as occupancy rate, cash flow, and cash on cash return. Thankfully, Mashvisor allows you to do a comprehensive investment property analysis easily and accurately. Sign up for Mashvisor now and get 15% off.
Related: Cap Rate vs. Cash on Cash Return