What is a good cap rate?
If you’ve been around real estate investing for any period of time, you’ve likely heard the term “cap rate”.
But what is a cap rate? What is a GOOD cap rate? As an investor, when should you use it? Does it really matter?
In this article, we’ll dig in to answer those questions and aim to give you some real life perspective on the value of cap rate.
What is a cap rate?
So let’s start at the beginning and define cap rate.
Here is how Wikipedia defines it:
Capitalization rate (or “cap rate“) is a real estate valuation measure used to compare different real estate investments. Although there are many variations, a cap rate is often calculated as the ratio between the net operating income produced by an asset and the original capital cost (the price paid to buy the asset) or alternatively its current market value.
In other words, it’s a formula that helps you compare the income a property produces against the cost of purchasing that property.
Why is cap rate important?
So why do we care about cap rate?
In short, once you’ve found a handful of investment properties, cap rate allows you to compare those opportunities without the consideration of the financing component.
This is important because it really allows you to evaluate the asset by itself; without the complexities of the financing variable.
To put this differently, imagine that you had two identical properties that provided the same exact cap rate. But, for some reason, the bank provided you with one loan that was at 4% and another that was at 14%.
If you included the financing portion into your calculation, the performance numbers for the two identical properties would obviously look very different.
Cap rate formula
As shown above, to find a property’s cap rate, you are simply going to divide the net operating income by the price.
Net Operating Income
As the name suggests, net operating income is essentially your income minus your operating expenses.
For a rental property, you’d typically have the following expenses you’d want to deduct each month:
- Property taxes – Will vary. Can typically look up on the property appraiser’s site to get an idea though.
- Property Insurance – For estimate’s sake, add $90 for every $100,000 financed.
- Property management – Typically 10% of the monthly rent.
- Property maintenance – Again, for estimate’s sake, multiply the monthly rent by 0.1.
Here is a great explanation on how to calculate net operating income for a rental property.
How to look at “Price”
So if you search the Internet, here is where you’ll some times see differences in how people are calculating the “price” part of the equation.
Since the goal is to use cap rate to compare investment opportunities, I prefer to think about this as the “Acquisition Price”.
In other words, the entire cost (other than financing) of getting in to a property. This could include the following:
- Purchase price
- Closing costs
- Repair costs
- Holding costs (if you have to repair before you can rent)
The important thing here is that you look at price the same way I do, it’s that you find your own way to compare apples to apples.
To keep it simple, many people just use the listing price.
When (and how) to use it as an investor
If you’re a Commercial real estate investor, you’ll obviously use cap rate all the time.
This is standard practice.
However, another great opportunity to use it, as a residential investor, is when you are trying to compare a single family property to a multi-family property.
As we’ve talked about in the past, the financing on a multi-family investment will differ from that of a single family investment. Therefore, it’s a good idea to use the formula to compare how well the two opportunities produce.
Once you’ve done that, circle back and use a ROI type formula to compare the two WITH the financing variable. This sort of calculation is common place with those attempting to BRRRR properties.
What is a good cap rate?
So, to come full circle here, what is a good cap rate?
The short answer here is, at least in Tallahassee, somewhere between 8 and 12%; but more often than not, 10%.
The longer, more accurate answer, however, is that a good cap rate is specific to the investor. If you are willing to accept more risk, than a good cap rate will reflect that.
The opposite is true if you are unwilling to accept a lot of risk.