What Is A Good Cap Rate For Your Investment Property?

Key Takeaways

  • What is a good cap rate? The answer is simple: one that can justify the purchase of a subject property.
  • The cap rate vs ROI debate continues to this day, but the best investors value both equally.
  • A rental property cap rate will estimate approximately how much an investor can expect to make from acquiring a subject property.

A cap rate, otherwise known as a capitalization rate, is nothing short of one of the most important fundamental indicators for determining whether or not a property is worth pursuing. Not surprisingly, cap rates have proven instrumental in building some of today’s most prolific real estate investing portfolios, and there’s no reason it couldn’t help you do the same. In fact, I’d argue that you can’t even build a halfway decent portfolio without identifying the cap rate of each and every one of your assets; it’s that important. Therefore, it’s in your best interest to not only gain a better understanding of what a cap rate is, but also how to use it to strengthen your investing efforts.

What Is A Cap Rate?

A cap rate is one of the easiest and most dependable ways to quantify whether or not an investment deal is worth following through with. In its simplest form, however, a cap rate is nothing more than an equation; one that’ll identify how much an investor stands to make (or lose) if they end up buying the property in question. It is worth noting however, that a cap rate won’t provide investors with the exact amount they stand to gain, but rather an estimate. Cap rates are no more accurate than stock market predictions; they are subject to an inherent degree of error, and should, therefore, be “taken with a grain of salt.” I repeat, cap rates are not 100% accurate; they are merely used to estimate one’s potential return on his or her investment. That said, a properly estimated cap rate is invaluable when supported with due diligence and an acute attention to detail.

Cap rates are not intended to act alone; they are but one piece of the puzzle. A cap rate by itself is almost useless, but a cap rate with supplemental data and information can significantly mitigate the amount of risk an investor will be exposed to over the course of an investment. And therein lies the benefit of learning how to calculate cap rate: the resulting number can mitigate more risk than many investors realize. If you know how much an investment could potentially make, it stands to reason you’ll know whether or not you should pull the trigger on the purchase.

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What is a good cap rate?

How To Calculate Cap Rate

For as important as cap rates are, they aren’t as complicated to calculate as you would assume. In fact, learning how to calculate cap rate requires nothing more than basic division skills. Before you start calculating your own cap rate, you’ll need two things:

  • The property’s net operating income (NOI)
  • The amount it would cost to by the subject property

As you may have already guessed, calculating the cap rate is as simple as dividing the property’s NOI by the current market value or acquisition cost of a property.

It is worth pointing out that calculating a property’s market cap is contingent on gathering accurate information. Therefore, you will need to mind due diligence and make absolutely certain that you can pinpoint an approximate dollar amount the property should be able to make.

Differentiating Cap Rate Vs. ROI

As I have already alluded to, a cap rate is used to estimate the investor’s potential return on his or her investment. That said, it’s not hard to see why many that are new to the field of real estate investing would confuse a cap rate with return on investment (ROI). On the surface, the two metrics are very similar; they each tell an investor what they might expect if they move forward with an investment. It is worth noting, however, that these two metrics are used for two different things.

Return on investment is meant to give investors an objective percentage on how much they can expect to make on a deal. For example, ROI is typically expressed as a percentage, as to estimate the investor’s potential return on his or her investment. That way, investors can compare the ROIs of two completely different assets. The return on investment expressed as a percentage make it easier to compare two individual assets, whether or not they are the same. Investors can, therefore, compare the ROI of a three month rehab with a 30 year buy and hold.

The cap rate, on the other hand, is used to compare similar real estate assets. For example, a cap rate would be perfect for someone to compare returns from two rental properties, but far from ideal for the investor that wants to compare a rental property to a rehab.

What Is A Good Rental Property Cap Rate?

The concept of a “good” cap rate is more subjective than objective. If for nothing else, capitalization rates have become synonymous with risk more than anything else. Therefore, in order to determine a good cap rate, you just first identify how much risk you are comfortable exposing yourself to. According to Entrepreneur, “Different CAP rates represent different levels of risk.  Low CAP rates imply lower risk, higher CAP rates imply higher risk.” Therefore, you shouldn’t be asking yourself “what is a good capitalization rate,” but rather “what’s the right cap rate in proportion to the amount of risk you are willing to tolerate?”

An investment property cap rate may sound simple, but its implications are heavily weighted. After all, those that can accurately estimate a property’s cap rate stand a better chance at realizing success. Does that sound like something you could get behind? Please feel free to let us know your thoughts on cap rates in the comments below.

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Real Estate Investing Strategies
Real Estate Investing Strategies
Real Estate Investing Strategies
Real Estate Investing Strategies
Real Estate Investing Strategies
Real Estate Investing Strategies