What is a Good Cap Rate on Rental Properties?
A good cap rate on rental properties is typically anywhere between 5 and 12 percent but these numbers can vary due to many factors. Due to the diverse nature of real estate, cap rates serve a vital role in providing real estate investors, like yourself, a powerful tool to decipher what is a well performing rental versus a poorly performing asset.
That said, a large part of determining what a ‘good’ cap rate depends on a full range of factors. Because it can get confusing, very quickly, this article outlines everything you need to know about cap rates and how to use them to expand your rental property portfolio.
What is a cap rate?
A capitalization rate, or cap rate for short, is a term used by real estate investors to quickly assess how well a real estate asset performs. In other words, it is a metric used to evaluate the rate of return on an initial investment. Further, cap rates are often used to judge how risky or safe a rental property investment may potentially be for a real estate investor.
When do you use cap rates?
Real estate investors typically use cap rates when they are thinking of buying an income generating residential real estate asset. This can include multifamily apartment buildings, mobile home parks, as well as single-family residences, condos, and townhomes that are rented out.
Cap rates are also commonly used in the commercial real estate space, enabling property owners to analyze how well retail storefronts, commercial office spaces, industrial spaces and hotels are performing. Overall, property owners and investors find them extremely useful when studying potential rental property to purchase.
How do you calculate cap rates?
Cap rates can be calculated by taking the net operating income that a property generates, dividing it by the market value of the property, and multiplying the result by 100 to get a percentage.
Cap Rate = (Net Operating Income / Current Market Value) X 100
Net operating income is simply the income generated by the property less the operating expenses to run it, such as utilities, insurance, estimated maintenance fees, property management fees, depreciation, vacancy rates, etc. (This is not to be confused with ‘net income’ which is net operating income less the cost of underlying debt payments). As an investor you will typically receive marketing materials outlining the current rent schedule, as well as the different operating expenses, which makes it easier to calculate these.
Net Operating Income = Gross Rental Income – Total Operating Expenses
Market value, however, can be deduced in several ways. For a rental property that is already listed on the open market, use the asking price may be used for the market value, or even the value of the property to you. Similarly, you can also use the comparable property approach, which entails finding rental properties of the same size, structure and characteristics, researching their prices, and generating a comparable market value.
If you are weighing multiple rental properties, it is important, however, to keep all ‘inputs’, so to speak, into the formula consistent. Meaning, if you use the list price for market value on one property to calculate cap rates, this same method should be employed on the others.
A Cap Rate Example
To fully understand cap rates, let’s do a quick example. Let’s assume Sally Seller is offering to sell her duplex to Bobby Buyer for just $300,000. Bobby thinks this is a fair market value, and is intrigued that one unit is rented for $1,250 a month, and the other for $1,500. While the tenants do pay for their own utilities, Sally uses a property management company that charges 10% of the gross rents, and pays on average 15% a month in maintenance and miscellaneous repairs. In this example the following calculations would be:
Gross rental income = ($1,250 + $1,500) a month x 12 months = $33,000
Total Operating Expenses = $33,000 x 25% in operating expenses = $8,250
Net Operating Income = $33,000 – $8,250 = $24,750
Current Market Value = $300,000
Cap Rate = ($24,750 / $300,000) x 100 = 8.25%
The property has what we would consider a good cap rate in any area of 8.25%. Don’t worry. If your head is still spinning from the math, there are many cap rate calculators available online.
Why use cap rates?
Of all the different financial attributes of a rental property, such as list price, gross rents, or net profits, cap rates are the most ideal way to compare properties on equal footing because they are expressed as a percentage.
If, for example, you are considering purchasing a 4-unit apartment building for $750,000 that generates $50,000 in annual net operating income of $50,000 or a 6-unit building that costs $850,000 that generates $61,625 in annual net operating income, it may initially be tempting to settle on the first property. I mean, is it really worth paying $100,000 more for just a $10,000 a year boost in income.
The answer is yes! While the 4-unit building is cheaper it has a cap rate of 6.67%, while the 6-unit building has a cap rate of 7.25%. Cap rates are extremely useful for the technical investor because numbers at face value hide many different important factors.
What does a cap rate actually tell me?
In general cap rates should tell you what percentage of the money you invested in a rental property, should you expect back as a return over the course of a 12-month time period.
In the world finance, cap rates also give you an indication of the level of risk a rental property carries. Risk in real estate is often made in comparison to 10-year treasury bonds, which typically yield investors 3% each year and are generally considered risk-free or ‘safe’, as the federal government will always have money to pay its obligations.
This is important to know, because how well a rental performs compared to these risk-free treasury bond rates can tell investors succinctly whether or not the property is even worth the hassle. If a property’s cap rate rises above these ‘risk-free’ rates, this premium, or profit to the investor, is lucrative, but comes at an additional cost.
That cost is the risk of multiple influences and fluctuations in the market, which can be anything on a macro level from low interest rates or changes in consumer demand for housing, to items on a more property specific basis, such as the age and condition of a property, the timing of payments, or the structure of the rent or leases.
Typically, as a real estate investor you want a high cap rate because you are receiving a greater return for every dollar of being purchased price of the property. the only caveat is a higher cap rate typically indicates that the asset is carries greater amounts of risk than a property with a low cap rate. The type of cap rate you specifically want really will depend on your personal investment goals, as well as your risk tolerance.
What affects cap rates?
In order to assess what is a good cap rate for a rental property it is important to take into consideration all the different factors that affect a cap rate. Because they are directly tied to the market value of a property, they tend to fluctuate with the several market influences which are commonly:
Location is single handedly one of the largest drivers of cap rates in real estate. Areas that are in high demand, are stable, or are otherwise experiencing little to no growth, may have cap rates on the lower end of the 5 to 10% range. On the other hand, areas in the pathway of neighborhood redevelopment, or gentrification or in high growth and expanding economies may have rental properties performing with cap rates on the higher end of this spectrum.
Additionally, cap rates are all relative to location. What may be considered a good cap rate in one city, county, or even street, may be considered a poor cap rate in a different area. Bearing this in mind, as a real estate investor, before you think about throwing a property into the no pile, make sure you research what the local cap rates in the area should be.
Local Market Trends
Returning to our calculation of cap rates, the market value of a property plays a central role in the cap rates of a real estate asset. As such, how well the local real estate market is doing will heavily affect cap rates. If you are in an area where it is a seller’s market, for example, and a lack of housing and rentals are driving prices up, then you can expect cap rates to be higher. At the same time, if you are thinking of purchasing a rental property in an area with a glut of housing or currently experiencing a buyer’s market, in which sellers are motivated to drop their prices, cap rates will likely tend downward as well.
The type of property in question also plays a role in influencing cap rates. Rental properties that are 1 to 4 units are still largely considered residential property, and typically experience cap rates that are more stable and on the lower end of the spectrum. This is largely because at the end of the day everyone still needs a place to live, and due to the nature of long-term rental and lease agreements there is reasonable assurance of a consistent flow of operating income. Conversely, rental properties with 5 or more units are considered commercial property and carry a greater amount of risk. These assets typically have higher cap rates because there is more risk involved in trying to maintain if fully occupied building as well as greater operating expenses.
As you will have seen in our earlier example average vacancy rates in an area will affect the cap rates of a rental property. Vacant units mean no income is being generated to offset the expenses that continue to accumulate on a property. When investing in rental properties, especially in an area you are unfamiliar with, it is important to research the average occupancy rates. Areas with higher than average vacancy rates, for example, may appear to be solid investments on paper and based on the price, but yield little to no return, which will in turn be reflected in lower cap rates.
Types of Tenants
Because tenants are directly responsible for bringing income into a property, the type of tenants your rental property has will directly affect your cap rate. In real estate, assets are typically differentiated classes: Class A, Class B, and Class C. Class A rental properties are usually newer buildings that attract the most highly qualified tenants that pay each month on time. Class B and Class C tenants are typically consumers with less than ideal credit with more cyclical employment and inconsistent sources of income. This is an important consideration because, as an investor, if you are presented with a fully occupied building generating $55,000 a year in an economic boom time, if the building is occupied by Class C tenants, a simple economic downturn or recession may send your net operating income down and cap rates plummeting.
When to avoid using cap rates?
While cap rates can be a beneficial tool for real estate investors, it is important to avoid using them on properties that do not make money. At the end of the day every property has some type of market value, but not all rental properties may be generating the net operating income that is required to calculate cap rates. Perhaps the rental is a new build and hasn’t been leased out yet. Perhaps it was completed vacated to leave you the opportunity to complete renovations, and raise rents to market rates. Perhaps, even still, it is a property that is rented out as a vacation rental or Airbnb. In the case of the latter, the shorter time spans will throw off cap rates, and can generate artificially high or low numbers that defeat the ultimate purpose of the metric.
Additionally, you will want to avoid using cap rates if you play to use a loan to purchase the property. By their nature, cap rates do not account for interest, monthly mortgage payments, or points paid to a lender, all of which are arguably the most significant expenses when it comes to operating a rental property. Cap rates typically operate under the assumption that you are bringing in all cash to a deal, and because loan terms will differ for each property, cap rates should not be too heavily relied on in these instances.
How do you find cap rates in your area?
Fortunately, because real estate is a heavily documented industry, it can be relatively easy to locate the average cap rates in your area. Commercial real estate sites like Loopnet and CoStar do an excellent job of generating reports on cap rates across the country, and usually within their listings will calculate the cap rate for you.
Local commercial real estate brokers can also offer an accurate accounting of cap rates in your area, as they are the ones typically on the front line of deals and price negotiations.
Additionally, there are multiple private data companies that track cap rates by county and according to different asset types.
How long do cap rates last?
By their very nature, you should not use the same cap rate for a rental property longer than 1 to 3 months. Cap rates are not stale figures. They are subject to change and can change quickly, thereby defeating their entire purpose, which can be counter intuitive in real estate, where deals tend to move very slowly. Especially if you’re trying to secure financing to supplement your purchase. For this reason, it is critical than you continually update the cap rates you are using to compare several rental properties.
Overall, as a real estate investor you should use cap rates because they offer a simple, straightforward, and dependable method to quantify the value of a rental property as an investment. No matter how many deals you may come across, or how many properties promising six-digit annual returns you are a pitched, a good cap rate will be the same across the board, making it a must-have in the investor’s toolkit.
It is, however, important to keep in mind though that cap rates are merely an estimate of expected return, and are not a full a guarantee. Even the most prudent real estate investors should use cap rates in conjunction with other data, metrics, and analytics during your due diligence period in order to identify and mitigate any and all risks related to the potential rental property you are considering acquiring.