What's a good cap rate for investment properties?

Knowing what a good cap rate for an investment property is one of the most popular questions in the world of real estate investing. And like most widespread questions that bother the minds of many people, it is a complicated one with no single, straightforward answer.

To begin with, let’s define cap rate. Capitalization rate, or cap rate for short, is one of the most commonly used metrics to measure the profitability of a real estate investment. It describes the rate of return of a rental property regardless of the method of financing. In theory, the cap rate is a measurement of the level of risk associated with an investment property. A lower cap rate corresponds to a lower level of risk, whereas a higher cap rate means a higher level of risk in the deal. This is only logical as in investing low risk is associated with low profitability, while high risk is related to the possibility for big gains.

So, how do we calculate the cap rate?

The formula is simple: The cap rate equals the net operating income (NOI) divided by the property price (or value).

Cap Rate = NOI/Price

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NOI: To calculate the NOI, you need to start with the annual rental income from an investment property and subtract from it all costs associated with operating the property, including taxes, insurance, management costs, utilities, maintenance, and others. The basic cap rate formula, as we show above, assumes that acquisitions are all paid for in cash and do not involve finance costs. If you, however, are financing a purchase (through a bank loan, let’s say), you will need to include the annual cost of financing your property as an operating expense.

Price: The price is the price that you pay for the rental property in addition to all other acquisition costs such as brokerage fee, closing costs, rehab costs, etc.

Example:

Let’s say it costs you a total of $170,000 to buy a rental property. You can rent it out for $1,500 per month. All annual costs related to your property add up to $3,000. To calculate the cap rate:

Cap Rate = NOI/Price

NOI = annual rental income - annual operating costs = 12 x $1,500 - $3,000 = $15,000

Price = $170,000

Cap Rate = $15,000/$170,000 = 8.82%

So, your cap rate is 8.82%.

Now that we’ve gone over how to calculate a cap rate, let’s go back to the initial question of what’s a good cap rate for an investment property. There is no unanimous answer to this question. However, most experts tend to agree that the cap rate should be around 10%. For most rental properties around the U.S., the cap rate is between 8% and 12%.

There are several factors which account for the various cap rates which might be acceptable for a particular property:

First, the cap rate varies based on the asset type. For instance, multifamily properties consistently have the lowest cap rate because they are considered to provide among the lowest risk. The reason is simple. Apartment buildings generate their rental income from numerous tenants every month. So even if one or two of your tenants don’t pay their rent for a certain month, this represents a relatively small change in your cash flow for this particular month. Conversely, imagine a large, luxurious house that you out to a single family. If for whatever reason the tenants don’t pay their rent for this month, you as a landlord are left with 0 income. The risk is high.

Second, the cap rate is different in different markets. As you’ve heard many times, in real estate investing location is everything. States, cities, and neighborhoods all have different cap rates. This is partially because rents, operating costs, and acquisition costs change from one place to another. They also change over time. Different markets also exhibit different supply and demand, which will also cause significant differences in the cap rate. Thus, while the cap rate can be useful to compare the risk and the profitability of comparable properties in the same market, it simply does not make sense to decide on whether to buy a small apartment in Boston or a two-story house in Miami based on the cap rate. As a general rule, set the average cap rate in the area that you are considering as your minimum goal when purchasing an investment property.

Related: How To Do Investment Property Analysis

In conclusion, the cap rate is a helpful metric to use when shopping for a market and for an individual property. However, you should not base your final decision of whether to buy a certain property or not entirely on the cap rate that it offers. A major disadvantage of the cap rate is that it doesn’t take into consideration the depreciation/appreciation of a rental property, which plays a major role in determining the return on your real estate investment. Also, it does not account for the way of financing your property. Importantly, the cap rate might be misleading in growing markets. For example, even if the cap rate is not great at the moment, it might be worth investing in a property in a market that is set to grow as you will be able to enjoy higher rents and a significant appreciation of your property in a few years.

When looking for an investment property, remember that clicking on any of the thousands of listings on Mashvisor will automatically show you the cap rate for any listed property rented traditionally or through Airbnb. Naturally, these two methods will generate different cap rates. Moreover, Mashvisor allows you to filter listed properties by cap rate, as well as cash on cash return and rental income among others, to find quickly properties throughout the U.S. which meet your requirements and needs as a real estate investor.