When you first get into real estate investing, cap rate is the first term you will stumble upon. You’ll often hear other investors say things like “this rental property has a 7.5% cap rate”. But what does 7.5% cap rate mean exactly?
Short for capitalization rate, the cap rate is not the easiest concept to grasp. And so, naturally, carrying out a cap rate calculation is often a difficult task. Luckily, you don’t actually have to go about calculating cap rate yourself. All you need to do is make sure you have a general idea of what the cap rate is and what information it reveals about the rate of return on a rental property.
In this article, you will learn what is the formula for cap rate, how to calculate a cap rate, and what does 7.5% cap rate mean?
So, What Is Cap Rate in Real Estate?
One question you’ll often hear from real estate investors is, “What is cap rate?” What does cap rate mean? Cap rate (or capitalization rate) is a term used by real estate investors to measure the expected rate of return on an investment property for sale.
It’s the most commonly used metric by which real estate investments are evaluated. The metric is based on the ratio of the net operating income (NOI) that the rental property is estimated to generate to its fair market value. Calculating real estate cap rate is important before deciding to buy property because this helps you:
#1 Compare Different Properties in Your Market
What is a cap rate? How can it help real estate investors? Cap rate is most useful for investors when comparing different properties in a given market.
If there are two properties for sale on the market at completely different prices, it can be difficult to determine which makes for the better investment. Just because one is listed at a cheaper price, it doesn’t necessarily make it a better investment.
Instead, it’s important to understand how much of a return on investment each property is likely to produce. Comparing two cap rates can help an investor quickly make this determination.
#2 Have an Indicator of Potential Risk
Beyond a simple math formula, cap rate real estate is best understood as a measure of risk. Rental properties with higher cap rates are typically located in areas that are developing and, thus, come with more risk. Likewise, properties with lower cap rates are typically located in areas that are more stable (often with greater demand) and, thus, are less risky.
This is why cap rates are lower in hot markets like San Francisco. There’s so much demand here that investors are willing to accept lower returns due to the lower perceived risk. This drives the overall cap rate in the market down.
Related: Is a Higher Cap Rate Better for Investing in Rental Properties?
How to Calculate Cap Rate on Rental Property
So how do you calculate cap rate of a rental property for sale? What is the cap rate formula? There are actually a few different methods that are used to calculate cap rate. But, we are going to focus on the most common and easiest formula that you can use. Based on the definition of the capitalization rate, the cap rate formula is as follows:
The net operating income (NOI) is the expected annual income that the property will generate. And the net operating income formula is (Annual Gross Rental Income – Annual Operating Expenses – Vacancy Expenses). Let’s take a look at an example of how to calculate cap rate. Say that you’re evaluating a rental property for sale that is priced at $300,000. Here’s how you’d do the calculations using the formula for cap rate:
Step 1: Find out what the property’s fair market value is. Many real estate investors simply use the price which, for our example, is $300,000.
Step 2:Calculate the annual gross rental income. This is just the amount of rent you collect from your tenants in a single year. For this rental property, it’s $30,000 per year.
Step 3:Next, find out what the vacancy rate for the rental property would be. Let’s set our vacancy rate to 2%.
Step 4:How much will the operating expenses amount to? If the rental property requires $575 in expenses a month, that’s a total of $6,900 a year.
Step 5:Now, calculate the net operating income. You’ll find that it’s equal to $22,500.
Step 6:Finally, use the cap rate formula real estate now that you have both the NOI and the property value.
In this example, we’ll get to the conclusion that this rental property has a 7.5% cap rate. You can use the above cap rate formula calculator to compare similar investment opportunities and which has a better cap rate. Alternatively, instead of running all these numbers to calculate cap rate by hand, you can use one of the best real estate investment tools for investors that estimates your potential rate of return. This tool is…
Mashvisor’s Real Estate Cap Rate Calculator
Calculating cap rate once you own an investment property is relatively easy when you keep records of monthly rental income, recurring operating costs, and vacancy rates. But, calculating cap rate of a property before you buy it can be difficult, especially when you don’t have property data.
This means you’ll need to search for and gather this data, organize them in an investment analysis spreadsheet, and then run the numbers manually. And if you’re comparing a number of properties for sale, you’ll have to do this multiple times. Imagine having to calculate the cap rates of dozens of properties until you find the best one. Needless to say, this will be very difficult and time-consuming even if you know how to calculator cap rate.
The Cap Rate Calculator offers a more convenient way for real estate investors. It saves both time and effort when you calculate cap rate as it provides readily-available estimates of cap rate for any property in the US housing market. You can analyze properties available on the platform and even add your own properties.
Mashvisor will then prepare a rental property analysis that includes all the necessary metrics used in calculating the return on investment. These include not just the cap rate, but also the expected rental income, operating expenses, cash flow, cash on cash return, and occupancy rate.
This data is accurate as it’s based on property values and rental comps in the area. Therefore, the cap rate calculator is a must-have tool, especially for beginner investors. Learn how to calculate cap rate calculator to get the most accurate results.
Related: 5 Best Real Estate Investment Tools
Mashvisor’s Cap Rate Calculator
Sign up for Mashvisor to start looking for and analyzing properties with high cap rates anywhere in the US!
What Is a Good Cap Rate in Real Estate?
In theory, an investment property with a higher cap rate is considered to be a better real estate deal. That’s because such a property would be making a lot of money relative to the amount invested into it. On the other hand, a lower cap rate indicates that you’re investing more money into a property that will provide a lower return on investment.
However, there are a few critical things to keep in mind. First, the term “good” is more subjective than objective. Thus, the short answer to what is a good cap rate depends on how you’re using cap rate in real estate. Furthermore, cap rate in real estate has become synonymous with risk. So to determine a good cap rate for rental properties, you first must identify how much risk you’re comfortable exposing yourself to.
Generally speaking, the majority of real estate professionals have reached an agreement that a good cap rate for an investment property is in the range of 8% – 12%. In other words, this is the perfect balance between the rate of return on a rental property and the level of risk that it brings.
However, there are other factors to take into consideration as they affect cap rates and, therefore, what’s considered a good rate. Let’s take a look at each one of these factors so you can understand them better as a beginner real estate investor.
Factors That Affect Capitalization Rates
When analyzing a potential investment property to decide on the right cap rate, there are three factors to look at;
#1 Real Estate Market (Marco-Level Economics)
Location is everything in real estate investing, so it makes sense that it affects cap rates. To know what an acceptable cap rate for your property is, you need to know the cap rate for a real estate market.
Each city or market has its own set of underlying economic fundamentals like the median price, employment rate, job market, etc. These fundamentals have a huge impact on risk and, as a result, cap rates. This is why what’s considered good in one market might be very low in another.
For example, investors will accept a 5% cap rate in the New York real estate market because it’s less risky based on its economic fundamentals. But they won’t consider 5% a good cap rate in a market that they perceive as riskier, like the Memphis real estate market.
#2 Neighborhood (Micro-Level Influences)
Capitalization rates also differ by neighborhood within the same city or real estate market. This also goes back to economic fundamentals and also geographic location. For example, home prices are generally higher the closer the neighborhood is to downtown and key infrastructure like mass transit, ports, highways, etc. This is why you’ll see lower cap rates to be the norm in these neighborhoods.
In contrast, you’ll see higher cap rates in a lower-demand area or an up-and-coming neighborhood that is in the process of redevelopment. You can find out cap rates for neighborhoods in any city in the US using our Real Estate Investment Calculator. This tool will also provide you with Neighborhood data to run a complete neighborhood analysis. It will also help you better understand what does 7.5 cap rate mean.
#3 Type of Investment Property
Lastly, cap rates vary across different property types because not all types are created equal when it comes to perceived risk. For example, multi-family homes have lower cap rates than other types because they provide lower risk. This is true as people always need places to live, even during economic downturns.
Commercial and retail properties, on the other hand, can struggle during these times. Also, if you’re investing in a multi-family real estate of four units, for example, you’ll have more than one income stream. So if one tenant doesn’t pay rent, it wouldn’t affect your income. If this happens to real estate investors of single-family homes, they have a higher risk of negative cash flow.
The Bottom Line
The cap rate is an ROI metric that is most valuable when used to compare against similar rental properties for sale. That is, properties with a similar location, of the same type, and which are valued at the same point in time. Now that you know the cap rate formula and what does 7.5% cap rate mean, there’s one last important note to remember regardless of which property type you choose to invest in.
Any smart real estate investor must thoroughly evaluate the cap rate for the specific property they’re buying to ensure it is “good” for the market. It’s best to avoid buying rental property with a super low cap rate when you can easily find properties for sale with cap rates as high as 7.5%.
Mashvisor’s tool will help you find the best investment properties in the best neighborhoods and cities according to the cap rate and other metrics. To access our tool, click here to start your 7-day free trial with Mashvisor and get a 15% discount after!
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Eman is a Content Writer at Mashvisor. With a focus on market reports, she enjoys researching the state of the real estate market in different cities across the US. Eman also writes about trends, forecasts, and tips for beginner investors to gain the confidence and knowledge they need to make wise decisions.
Is 7.5 A good cap rate? ›
Rule of thumb states that a good cap rate is between 4-12%. However, where on this scale is best for you will depend on how much risk you can deal with. More risk is a higher reward, and so a higher cap rate, while lower risk should be closer to 4%.What is a good cap rate for a property? ›
Generally, a high capitalization rate will indicate a higher level of risk, while a lower capitalization rate indicates lower returns but lower risk. That said, many analysts consider a "good" cap rate to be around 5% to 10%, while a 4% cap rate indicates lower risk but a longer timeline to recoup an investment.What does cap rate show you? ›
The cap rate of a property is determined based on the potential revenue and the risk level as compared to other properties. Importantly, the cap rate will not provide a total return on investment. Instead, it will indicate an estimate of how long it will take to recover the initial investment in the property.How does a cap rate work? ›
The market capitalization rate, or “cap rate,” of a commercial real estate investment property is easy to define: It is the Net Operating Income (NOI) divided by the property's market value. In other words, how much money an asset brings in each year divided by how much the asset itself is worth.What is a good cap rate 2022? ›
Cap rates to hold steady
The all-property average cap rate is expected to be 280-300 basis points (bps) higher than the 10-year Treasury yield during the first half of 2022, on par with the 290-bp average from 2013 to 2018, before narrowing to 250 bps in H2 2022.
Buyers usually want a high cap rate, or the purchase price is low compared to the NOI. But, as stated above, a higher cap rate usually means higher risk and a lower cap rate usually means lower risk.What is a good cap rate for rental property in 2022? ›
A good cap rate for multifamily is anywhere over 4% and under 10%, depending on where you are in the market cycle, geographic location, property condition, and the balance of supply and demand of rental units in a particular region. A higher cap should usually be expected in areas with low demand for rental properties.Will cap rates go up in 2022? ›
According to Cap Rate Survey estimates retail cap rates were flat to trending downward during H1 2022. Retail cap rates will likely see some upward movement; however, renewed interest from institutional buyers could put a ceiling on the increase in coming quarters.Is mortgage included in cap rate? ›
Does a cap rate include mortgage? No, the cap rate calculation does not include your mortgage payments. The formula for calculating cap rate includes your annual net operating income, minus annual expenses other than your mortgage. (Then, you'll divide that number by the home price to get your cap rate.)Why is a high cap rate more risky? ›
Overall, the higher the cap rate, the riskier the investment. That is, a high cap rate means your asset price is low, which typically points to a riskier investment.
What makes cap rates go up? ›
Rising Interest Rates: As a general rule of thumb, cap rates tend to go up when interest rates rise. This movement reflects the increased cost of borrowing, which means that returns also need to rise in order to maintain the same level of profitability. To achieve higher returns, property prices have to fall.Does higher cap rate mean higher value? ›
Cap rates generally have an inverse relationship to the property value. The lower the cap rate, the higher the purchase price and vice versa.Does cap rate include closing costs? ›
Next, divide your net operating income by the total acquisition cost for the property, including brokerage fee, closing costs, and all the rehab costs necessary to make it “rent ready.” The result will be your cap rate, expressed as a percentage.Does cap rate include taxes? ›
It is calculated as net operating income divided by the current market value of the property. Net operating income, which is one of the inputs in the cap rate formula, is a pre-tax metric which means that the cap rate is also a pre-tax metric.What is a 7% cap rate? ›
The cap rate is an asset's unlevered (no mortgage) return, and a reflection of an asset's relative risk. If the buyer were to purchase the property all cash in the example above, and if the property distributes the same net operating income, the buyer would receive a 7% return on their investment.What is the average cap rate for rental property? ›
A good cap rate hovers somewhere between 8% and 12%, but the real answer is: It depends. While a 10% cap rate might be solid for some rentals, your percentage is not the only factor in determining whether taking on an Airbnb investment is right for you.Do cap rates rise with inflation? ›
So how does inflation affect cap rates, and ultimately sale values? Historically, cap rates will move with interest rates. As interest rates go up to stave off inflation, the cost of capital for borrowers goes up, and therefore the returns needed from their investments need to increase as well.What happens when cap rates go down? ›
A lower cap rate means an investment is less risky. It's the same principle that gives you a lower return for low-risk assets like Treasury bonds (1.91% for 30-year bonds as of 8/27/21) than for more risky assets like stocks (average annual historical returns close to 10%).Do appraisers use cap rate? ›
Investors, lenders and appraisers use the cap rate to estimate the purchase price for different types of income producing properties. A market cap rate is determined by evaluating the financial data of similar properties which have recently sold in a specific market.Why does property value decrease when cap rate increases? ›
A higher cap rate indicates that the expected returns from a property are riskier and investors will pay less for such property; a lower cap rate represents a less risky property and, hence, an investor will pay a higher price and receive a lower yield.
Why do sellers want low cap rates? ›
For example, if you are selling a property then a lower cap rate is good because it means the value of your property will be higher. On the other hand, if you are buying a property then a higher cap rate is good because it means your initial investment will be lower.Is 2022 a good year to buy a rental property? ›
2022 is a balanced year for housing supply and demand. This is ideal for retail purchasers and rental property investors. No longer a “seller's” market. Rising interest rates raise the monthly mortgage payment, which reduces homebuyers and lowers property values.Is property still a good investment 2022? ›
If you're thinking long-term or are planning for retirement, buying an investment property to rent is still a good investment in 2022. And it can get even better if you shop around carefully for properties at a good value with strong rent returns.Do cap rates rise with interest rates? ›
As shown in the chart above, higher interest rates contributed to an increase in the potential cap rate, but upward pressure from slower CRE price growth will be a much more significant contributor to the increase in the second quarter potential cap rate.Will rates drop again in 2022? ›
If spreads gradually return closer to historical averages, then mortgage rates will decline modestly over the next year. This is reflected in our forecast which has rates dropping from an average of 6.8% in the fourth quarter of 2022 to 6.2% in the fourth quarter of 2023.What affects the cap rate? ›
Cap rates are determined by three major factors; the opportunity cost of capital, growth expectations, and risk. Commercial real estate investments compete with other assets (e.g. stocks and bonds) for investment dollars.What expenses are excluded from cap rate? ›
However, you need to exclude mortgage payments (both principal and interest), property depreciation, capital improvements, and taxes. Mortgage payments are a financing expense, which is not included in net operating income. The cap rate does not change if you are financing the property or paying cash to buy it.What is a good cap rate for multifamily? ›
Due to their decreased risk, multifamily complexes have one of the lowest average cap rates of any property asset category. According to 2ndkitchen, a suitable cap rate for multifamily properties is often between 4% – 10%.Do cap rates make sense valuing property? ›
Cap rates can be useful when comparing two or more properties. Once you know the capitalization rate of each property, you can judge which one is producing the highest percentage of net operating income (NOI). Another way to think about cap rate is that it's a measure of how strong the property is.What is a good and bad cap rate? ›
In real estate, a low (less than 5%) cap rate often reflects a lower risk profile, whereas a higher cap rate (greater than 7%) is often considered a riskier investment. Whether an investor deems a cap rate “good” is a direct reflection of whether or not they think the investment's return matches to the perceived risk.
Is a 7.4 cap rate good? ›
In real estate, a low (less than 5%) cap rate often reflects a lower risk profile, whereas a higher cap rate (greater than 7%) is often considered a riskier investment.Is a 7.8 cap rate good? ›
When you take into account that most investors consider a cap rate of 10 percent or more to be positive, a rate of 7.8 percent gives an investor an idea about their return on the investment. Vacancy consideration: You can also account for a vacancy in your cap rate calculation as well.What does a 7.7 cap rate mean? ›
What is cap rate? It refers to the capitalization rate and is the net operating income divided by the cost. It's expressed as a percentage. For example, a 6-unit apartment building that has a net operating income of $30,065 and costs $390,000 would have a 7.7 percent capitalization rate.Is a 7.7 cap rate good? ›
This is because the formula itself puts net operating income in relation to the initial purchase price. Investors hoping for deals with a lower purchase price may, therefore, want a high cap rate. Following this logic, a cap rate between four and ten percent may be considered a “good” investment.Should cap rate be higher than mortgage rate? ›
If the cap rate is greater than the interest rate, you'll generally come out ahead. If the cap rate is lower than the interest rate, you'll be relying on appreciation for your return, making it a riskier speculative investment.Do you include mortgage in cap rate? ›
Importantly, the cap rate formula does NOT include any mortgage expenses. As you can see in the formula for net operating income below, the expenses do not include a mortgage or interest payment. Excluding debt is part of why a cap rate is so useful.Is an 8.5% cap rate good? ›
Cap rates also showcase the relationship between risk and return; a “low” cap rate of 3-5% would mean the asset is lower risk and higher value, while a “higher” cap rate of 8-10% reflects a lower price, meaning higher risk and a higher return.