When you’re buying a rental investment property, you need to know exactly what return on investment you can expect. You want to put your money where you’ll be able to generate the highest profit. One of the most widely used ROI metrics in real estate is the cap rate, short for capitalization rate.
In this article, we will look at the cap rate and answer all the most important questions about it. We’ll discuss what the cap rate is, how it is calculated with an example, and how to use it to make good investments. We’ll also go over what a good cap rate is, what its pros and cons are, and what alternative ROI metrics investors can use. Last but not least, we’ll show you how to use a cap rate calculator to make your investment decisions not only faster but also more profitable.
What a Cap Rate Is
The capitalization rate (cap rate) is one way to calculate and evaluate return on investment in real estate investing. Besides return on investment (ROI), the cap rate measures the risk that investing in a certain real estate property brings. While many financial experts associate this metric with commercial properties, the cap rate has been successfully applied in residential real estate investments too.
In rental property investing, the cap rate represents the ratio between the net operating income of a property and the property’s purchase price or current market value. It is represented as a percentage. Importantly, this ROI metric does not factor in debt.
Real estate investors can use the cap rate to calculate the profitability of both long term and short term rental properties. It works with different types of properties including single-family homes, multi-family homes, condos, apartments, and others. This measure can also be used at the market level as well to compare the returns offered by different markets.
What the Cap Rate Formula Is
The formula for calculating the cap rate is:
Cap Rate = Net Operating Income (NOI)/Sales Price or Current Market Value x 100%
In the cap rate formula, the net operating income (NOI) equals the difference between the gross rental income and the operating expenses that a property generates over the course of a year.
You need to subtract the following operational expenses from the gross income:
- Rental property management
- Rental property marketing and advertising
- Property maintenance and upkeep
- Short-term rental licenses and permits (for vacation rentals)
- Utilities and restocking (for vacation rentals)
- HOAs fees (for condos)
- Property tax
- Rental property insurance
- Vacancy
The operating costs exclude the monthly mortgage payments (both the principal and the interest).
In the cap rate formula denominator, investors can use:
- Property sales price for current purchases
or
- Property current market value for rentals that were obtained a while ago
Calculating the Cap Rate
Based on the formula above, the cap rate of a rental property is calculated by dividing the annual net operating income by the home value. To do that, a real estate investor needs to get access to accurate and reliable data on estimated rental income and all applicable operating expenses. In most cases, this is easier said than done, especially if you want to calculate the cap rate of an entire market.
Where to Get Cap Rate Data
The key to using cap rate to evaluate your real estate investments is to have access to the data that you need to plug into the formula. For beginners, it’s difficult to estimate how much revenue they will generate from running a rental property business and how much money they will spend on it before getting started. Unless you already own a rental property, and you have data from it, you’d need to look at the performance of similar rentals in the local market and base your estimates on that.
Here are the best sources of data that beginner investors can access:
- Awning: Awning’s Top Deals provides you with access to readily calculated cap rates for some of the hottest deals on long-term and short-term rentals across the US market. You can use Awning to search for available properties for sale in the US that promise to bring the best results for investors. For each listing, you see the estimated cap rate based on the performance of comparable rental properties in the areas. The built-in Awning Airbnb calculator eliminates the need to calculate the cap rate manually.
- Local real estate investors: You can try to network with landlords or Airbnb hosts available in the market. Many of them will provide you with figures on the performance of their rental properties. You can attend in-person meetups or join online forums.
- Real estate agents and brokers: Agents and brokers that work with investors frequently have access to rental property data to assist their clients. They can tell you what rental income and what rental expenses you can expect to face in the local real estate market.
- Property managers: Long-term and short-term rental property managers know how investment properties perform. You can consult with them on a property that you are considering buying to see what cap rate you can expect.
- Real estate websites: You can check out websites with listings for sale and rental listings like Zillow, Redfin, Realtor.com, and Rent.com to get unique data points like property prices and rental rates.
Cap Rate Calculation Example
Let’s look at specific examples in order to understand how the cap rate formula works in practice. Indeed, we’ll consider two different investment properties:
- Property A is a self-managed long-term rental
- Property B is a professionally managed short-term rental
Long-Term Rental Cap Rate Example
An investor purchased Property A (a single-family home) and is renting it out long-term while being a DIY landlord. He has the following:
- Purchase price: $950,000
- Monthly rental income: $5,500/month
- Rental property management: $200/month (business expenses)
- Rental property marketing and advertising: $300/year
- Property maintenance and upkeep: $3,500/year
- Short-term rental licenses and permits (for vacation rentals): $0
- Utilities and restocking (for vacation rentals): $0
- HOAs fees (for condos): $0
- Property tax: 1.2%
- Rental property insurance: $4,000/year
- Vacancy: 2%
Let’s do the calculations without using a cap rate calculator:
Annual Gross Income = 12 x $5,500 = $66,000
Annual Operating Expenses = (12 x $200) + $300 + $3,500 + (1.2% x $950,000) + $4,000 + (2% x $66,000) = $22,920
Net Operating Income = $66,000 - $22,920 = $43,080
Cap Rate = $43,080/$950,000 x 100% = 4.53%
So, Property A has a cap rate of 4.53%. You should note that it doesn’t matter whether the investor paid for the rental in cash or with a mortgage loan. The cap rate calculation ignores financing costs.
Short-Term Rental Cap Rate Example
Another investor purchased Property B (a condo) and is renting it out on a short-term basis. She’s hired an Airbnb management company. This investor has the following numbers:
- Purchase price: $600,000
- Average daily rate: $200/day
- Occupancy rate: 60%
- Rental property management: 20% of rental revenue
- Rental property marketing and advertising: $0 (included in management)
- Property maintenance and upkeep: $4,500/year
- Short-term rental licenses and permits (for vacation rentals): $200/year
- Utilities and restocking (for vacation rentals): $150/month
- HOAs fees (for condos): $250/month
- Property tax: 1.4%
- Rental property insurance: $5,000/year
We can do the calculations manually, without a cap rate calculator:
Annual Gross Income = 365 x 60% x $200 = $43,800
Annual Operating Expenses = (20% x $43,800) + ($4,500 + $200) + (12 x $150) + (12 x $250) + (1.4% x $600,000) + $5,000 = $31,660
Net Operating Income = $43,800 - $31,600 = $12,140
Cap Rate = $43,080/$950,000 x 100% = 2.02%
This means that Property B has a cap rate of 2.02%. While this house is cheaper, owning a short-term rental property is more expensive than owning a long-term rental. However, because of hiring a property manager, this investor can achieve passive income.
What Cap Rate Investors Consider Good
A good cap rate for rental properties is between 5% and 9%, depending on the market. Normally, investors would like as high of an ROI as possible. However, keep in mind that the cap rate measures not only the return but also the risk of an investment property, and you want to keep the risk within a reasonable limit.
The range of 5%-9% assures that the ROI is high enough to result in a profitable real estate rental property, while the risk is not at an unsafely high level. In most cases, properties in more desirable neighborhoods will have lower cap rates and vice versa.
Keep in mind that 5%-9% is a good cap rate for individual properties. When analyzing an entire rental market, investors consider 4% to 5% to be a good average.
How to Use a Cap Rate to Price a Real Estate Sale
Besides calculating the ROI of a rental property, the cap rate can also estimate the fair market value of a real estate property when buying or selling it.
Let’s say you want to invest in a rental property in a market. You are looking to generate a cap rate of 9% from the property, and you know from your network that similar rentals can bring a net income of $35,000. Then, using the cap rate formula in reverse, the sales price that makes sense for you is around $389,000.
9% = $35,000/Property Sales Price x 100%
Property Sales Price = $388,889
Alternatively, if you’re selling a property with net operating income of $40,000, and you know that the prevailing cap rate in the local market is 10%, you can easily figure out what price you should ask for your house.
10% = $40,000/Property Sales Price x 100%
Property Sales Price = $400,000
You should expect to sell your house to a real estate investor for around $400,000.
Evaluating Real Estate Investments Using Cap Rate
Besides estimating the fair price of a real estate property for sale, the cap rate has a few other beneficial applications in the investment world.
First, since the cap rate works at the market level, it can be used as an easy, yet accurate indicator to compare different locations to find the most profitable area for short-term and long-term rental property investments. This can be done at the state, city, and even neighborhood level. With the help of a cap rate calculator, you can find the average cap rates of the markets that you are considering in order to choose the optimal choice for your endeavor. Remember that the best cap rate value is between 8% and 12% to balance between ROI and risk.
Second, savvy investors use the cap rate to find the best deals for sale. Just as you can use this measure to compare between markets, you can use it to compare between properties. By finding out what cap rates different listings for sale promise, you can choose the one that is the right fit for your investor needs and requirements.
Third, if you already own a second home and can’t decide whether to turn it into a long-term or short-term rental property, the capitalization rate can help you. With a cap rate calculator, you can figure out which strategy promises to yield a higher ROI in your specific market, for your specific property. Just make sure to check the local short-term rental laws and regulations before starting an Airbnb business. You need to ensure that non-owner occupied vacation rentals are legal.
Last but not least, real estate investors use the cap rate to evaluate their existing rental properties and confirm that they are performing as expected. If you own an investment property that’s consistently able to bring a cap rate of 5%-12%, then you’re on the safe side. If not, look into alternative solutions like improving your marketing strategy, adjusting your rental rates, or hiring a rental property management company.
Benefits and Drawbacks of Using a Cap Rate
As a metric of return on investment in real estate, the cap rate comes with important advantages and disadvantages. Let’s have a look at the major ones.
The main benefits of using the cap rate over other ROI measures include:
- Easy calculation: Compared to other return metrics, the cap rate formula requires relatively few data inputs. It’s easier to calculate than most other real estate evaluations.
- Comparison between markets and properties: The cap rate allows investors to compare the investment potential of both entire markets and individual properties for sale. It helps them choose the best cities to buy rental property and the best listing to purchase.
- Straightforward interpretation: Once you calculate the cap rate, it’s easy to know if a deal is good or not. If a property promises a cap rate between 5% and 9%, it’s worth considering it.
- Measure of risk: It’s important to monitor risk when investing in real estate, and the cap rate allows you to do that. You should not fall for a property that promises to be very profitable if it’s very risky as well.
The main drawbacks of the capitalization rate are:
- No consideration of debt: The capitalization rate does not consider the debt that an investor takes on in order to purchase the rental property. Whether you pay in cash or with a loan has no effect on the cap rate, which makes the evaluation incomplete. How much you spend on an investment property is important for calculating ROI.
- Heavy data requirements: Although the cap rate formula requires fewer inputs than other real estate ROI calculations, you still need to collect a lot of data. Unless you already own a property that you want to analyze, you need to find reliable sources of real estate data.
- Reliance on assumptions: If you’re analyzing a potential property to buy, you will have to assume how it will perform as a rental. It’s hard to know for sure unless you have access to market-wide rental data.
- Difficulty to scale analysis: Calculating the cap rate of a couple of properties is easy, but calculations get very complicated if you want to analyze an entire market. Thus, you need to use a cap rate calculator.
Related and Alternative Ratios for Real Estate Evaluation
While the cap rate is an important metric when evaluating real estate investment deals, it is incomplete. That’s why it’s best to use it together with other ROI measures. The most popular alternatives include cash flow, cash on cash return, and internal rate of return (IRR).
Cap Rate vs Cash Flow
A key measure when analyzing rental properties is the cash flow. Positive cash flow indicates that you’re making money from your investment, while negative cash flow means that you’re losing money.
The cash flow is similar to the net operating income (NOI), but the fundamental difference is that the former also accounts for the debt service. How you finance your rental property and how much you pay for it per month affects your cash flow.
The cash flow formula is:
Cash Flow = Gross Rental Income - Gross Operating Expenses - Debt Service
Cap Rate vs Cash-on-Cash Return
Arguably the most comprehensive measure of return on investment in real estate is the cash on cash return. On the flip side, it is considerably more challenging to calculate than the less comprehensive cap rate. The major difference between the cap rate and the cash on cash return is that the latter takes into consideration the financing. Whether you buy an investment property in cash or with a mortgage loan reflects on the CoC return.
The cash on cash return formula is the following:
Cash on Cash Return = Annual Before-Tax Cash Flow/Total Cash Invested x 100%
Similar to the cap rate, the cash on cash return is shown as a percentage. The numerator comprises the gross cash flow that the property can generate before taxes, while the denominator is the amount of cash that you have invested in the deal. If you buy a house in cash, this is the total sales price plus any additional startup costs. If you use a mortgage, this is the down payment besides the closing costs and other cash investments.
In general terms, cash on cash returns are lower than cap rates on the same properties.
Cap Rate vs IRR
One other metric that real estate investors use to evaluate deals is the internal rate of return (IRR). The IRR measures the value that an investment property generates over the time that you own it. In other words, this is the return you earn on every dollar that you have invested in a property throughout the entire period that you hold it. In contrast, the cap rate measures the property’s ROI over a single year.
When you buy an investment property to rent out, the best course of action is to use the cap rate with the three other metrics explained above. This is the most accurate way to evaluate the profitability of an investment deal.
Cap Rate Calculator Frequently Asked Questions (FAQs)
While calculating the cap rate is easy in theory, things can get really complicated in reality. It’s rare that an investor wants to know the ROI of a single property only. Usually, investors want to compare the profitability of multiple deals on the market before choosing the best one. In this case, the cap rate calculator can help.
What is a cap rate calculator?
A cap rate calculator in an online real estate investment analysis tool which allows inventors to calculate the capitalization rate on multiple properties for sale without the need for Excel spreadsheets and manual calculations. This investment property analysis tool works with both short-term and long-term rentals.
With the help of a cap rate calculator, investors can estimate the forecast ROI on multiple listings for sale in a quick, efficient, and accurate way.
Where can you find the best cap rate calculator?
You can find an easy-to-use, reliable cap rate calculator right here on the Awning website. Our tool allows you to estimate the rental performance of any property in the US market as soon as you enter a few simple numbers.
How to use the Awning cap rate calculator?
To use the cap rate calculator on the Awning website, all you have to do is to enter the following data points:
- Property value: If you’re just buying a rental property now, this is the price that the homeseller is asking for.
- Annual gross income: If you plan to run a long-term rental business, this is the monthly rental rate multiplied by 12. If you aspire to be an Airbnb host, you need to multiply the average daily rate (ADR) by 365. You can find the ADR of vacation rentals in any US market in the Market Data section of the Awning website.
- Operating expenses: Most long-term rental property management companies charge a fixed monthly fee or a percentage of rental income. Airbnb management companies charge 10%-45% of rental revenue, so you need to enter the percentage relevant to your selected Airbnb manager.
- Vacancy rate: For traditional rentals, you can enter an average value of 5%. For Airbnb properties, the vacancy rate is the opposite of the occupancy rate and can vary widely. Once again, Awning Market Data gives you access to the average Airbnb occupancy rate in any US market.
As soon as you add the numbers, the calculator will provide you with:
- Annual net income: This will show you how much cash flow you are left with after covering all rental business expenses.
- Cap rate: This measures your expected ROI on a property.
Takeaway
As one of the most popular measures of return on investment in real estate investing, the cap rate has its own pros and cons. Overall, it provides a useful way to compare between potential markets and properties for sale to locate potentially profitable deals. However, before you decide on a property to buy, it’s advisable to resort to other metrics like cash flow, cash on cash return, and IRR as well. Using an online cap rate calculator proves to be beneficial as it eliminates the need for manual data calculation.
If you’re not sure where to find the most profitable long-term and short-term rental properties for sale, check out the Awning Top Deals. We provide you with the hottest opportunities for both rental strategies across the US market. All deals come with readily available analysis.
As a seasoned real estate investment enthusiast with years of hands-on experience, I can attest to the critical importance of understanding and utilizing key metrics when evaluating rental investment properties. In the realm of real estate, where the financial stakes are high, being well-versed in metrics like the capitalization rate (cap rate) is non-negotiable.
Let's delve into the concepts outlined in the article and provide a comprehensive understanding of each:
Cap Rate Basics:
What a Cap Rate Is: The cap rate, or capitalization rate, is a crucial metric used in real estate investment. It assesses the return on investment (ROI) and measures the risk associated with a particular property. It is widely employed in both commercial and residential real estate ventures.
Cap Rate Formula: The formula for calculating the cap rate is: [ \text{Cap Rate} = \frac{\text{Net Operating Income (NOI)}}{\text{Sales Price or Current Market Value}} \times 100\% ]
Cap Rate Calculation Example:
Long-Term Rental Cap Rate Example: Consider Property A, a self-managed long-term rental. The cap rate is calculated by dividing the annual net operating income by the property's value. For instance: [ \text{Cap Rate} = \frac{\text{Annual Net Income}}{\text{Property Value}} \times 100\% ]
Short-Term Rental Cap Rate Example: Similarly, for a professionally managed short-term rental (Property B), the cap rate calculation involves variables like average daily rate, occupancy rate, and various expenses.
Cap Rate Data Sources:
Where to Get Cap Rate Data: For accurate cap rate calculations, access to reliable data is paramount. Sources include online platforms like Awning's Top Deals, networking with local landlords, real estate agents, brokers, property managers, and consulting real estate websites such as Zillow, Redfin, Realtor.com, and Rent.com.
Evaluating Cap Rate:
What Cap Rate Investors Consider Good: A good cap rate for rental properties typically falls within the range of 5% to 9%, depending on the market. While higher ROI is generally desirable, it's crucial to balance it with an acceptable level of risk.
How to Use Cap Rate to Price a Real Estate Sale: The cap rate is not only a tool for evaluating potential purchases but also for estimating the fair market value of a property when buying or selling. The reverse application of the cap rate formula can help determine an appropriate sales price.
Benefits and Drawbacks:
Benefits of Cap Rate:
- Easy Calculation: The cap rate formula is straightforward compared to other real estate ROI metrics.
- Comparison Tool: It allows for easy comparison between markets and individual properties.
- Risk Measurement: The cap rate serves as a measure of risk, helping investors avoid excessively risky properties.
Drawbacks of Cap Rate:
- No Consideration of Debt: The cap rate does not account for financing, leading to an incomplete evaluation.
- Data Requirements: While less data-intensive than other metrics, sufficient data is still required.
- Reliance on Assumptions: Investors must make assumptions about a property's performance, introducing an element of uncertainty.
Related and Alternative Ratios:
Cap Rate vs Cash Flow: While cap rate measures overall return, cash flow assesses the actual cash generated, considering debt service.
Cap Rate vs Cash-on-Cash Return: Cash-on-cash return, a more comprehensive metric, incorporates financing considerations, unlike the cap rate.
Cap Rate vs IRR: Internal Rate of Return (IRR) measures the property's overall performance over its ownership period, providing a more extended perspective compared to the cap rate.
Cap Rate Calculator:
What is a Cap Rate Calculator: A cap rate calculator is an online tool facilitating the quick and accurate calculation of the capitalization rate. It streamlines the process, especially when evaluating multiple properties.
Where to Find the Best Cap Rate Calculator: Awning offers a reliable and user-friendly cap rate calculator on its website, allowing investors to estimate ROI efficiently.
How to Use a Cap Rate Calculator: Enter essential data points like property value, annual gross income, operating expenses, and vacancy rate. The calculator then provides annual net income and cap rate.
In conclusion, mastering the cap rate and its applications is indispensable for making informed and profitable real estate investment decisions. Investors should not only rely on the cap rate but also complement their analysis with other metrics to ensure a comprehensive evaluation of potential deals. Utilizing tools like the cap rate calculator can significantly simplify and enhance the decision-making process.
