The cap rate is essential to determine an investment property’s long-term profitability. What is a good cap rate for rental property? Moreover, what should you aim for as a real estate property investor? Let’s find out.
What Is a Rental Cap Rate?
The rental cap rate, also known as the capitalization rate, indicates the expected rate of return on a real estate property. It measures the profitability an investor can expect to generate. Moreover, it helps you determine the exit rate of an investment at the end of the holding period.
The cap rate represents the property’s yield over one year. However, it assumes that the property is purchased on a cash basis, not on a mortgage or loan. It’s useful for indicating the property’s un-levered and natural rate of return. On the other hand, it is not the sole indicator of profitability because it ignores the time value of money, leverage, and future cash flows.
How to Calculate Cap Rates for Rental Property
The cap rate for an investment property is usually expressed as a percentage. To calculate it, investors should use the following formula:
Capitalization Rate = Net Operating Income / Present Market Value
The net operating income (NOI) is the expected annual income the property will generate, for example, as a rental. You can calculate it by subtracting all the property management expenses, including maintenance and property taxes.
Meanwhile, the current market value is the property’s present value based on market rates. Others might also substitute this value for the purchase price of the property. The alternative formula is as follows:
Cap Rate = Net Operating Income / Purchase Price
However, using purchase price as a substitute has several flaws. Firstly, it misrepresents the property’s current market value if it was purchased several years prior. Houses bought in the past are often cheaper, and thus, you may end up with a bloated cap rate. In addition, there is no purchase price to use if the property is inherited. You would end up with a price of zero, which cannot be divided by.
Generally, the first formula is better because the current market value represents the property more accurately. Property values fluctuate widely, so current values are a more reliable return indicator.
What is a Good Cap Rate On a Rental Property?
What is a good cap rate for a rental property? The answer will depend on the property and investor. Generally speaking, higher cap rates generate higher returns, but they also come with higher risks.
What is the average cap rate for rental property? For most real estate investments, the average cap rate ranges between 4% to 5% at a minimum. However, a good cap rate falls around the 5% to 10% mark. Meanwhile, the best cap rate for rental property may be between 8% and 12% — if you have a risk appetite, that is.
On the other hand, this does not mean a cap rate lower than 5% is a bad thing. Lower percentages denote reduced risk, and they can also be beneficial. However, they also mean that the property owner will need more time to get a return on their investment.
Whether you’re comfortable with a lower or higher cap rate depends on your risk tolerance. Always consider the risk and your personal investment goals. There is no universally accepted “good” cap rate because it will depend on individual preferences and circumstances.
What Factors Affect the Cap Rate?
Several factors might impact the cap rate of a rental property. Often, the cap rate reflects the following:
- Interest Rates. High interest rates from high inflation can affect real estate cap rates. As interest rises, so do cap rates.
- GDP and Unemployment. The nation’s unemployment rate and GDP both affect cap rates. High GDP and low unemployment typically lead to lower cap rates because of lower risk.
- Location. The property’s location and proximity to essential services, popular locations, public transportation, and highways all affect its value. Properties in high-demand locations often have lower cap rates.
- Rent Growth. Higher rent and NOI expectations mean significant increases in interest rates. Declining economies can also raise cap rates and prevent rent growth.
- Competing Properties. Properties in well-developed markets with many competing properties will have lower cap rates.
- Property Investment. Investments in the property, such as renovations and enhancements, could affect the NOI and cap rate.
Other Factors to Consider
Nevertheless, determining a good cap rate for rental property is not the most critical indicator of success. There are many other factors to consider that may affect your long-term profitability.
1. Occupancy Rate
The cap rate’s standard formula assumes a perfect occupancy rate. This means that the unit remains occupied and rented for the entire one-year period. However, this is not always the case, as rental properties often stand empty for specific periods.
Hence, adjusting the NOI and accounting for an imperfect occupancy rate is important. Investors can change the formula for net operating income as follows:
NOI = (Occupancy Rate x Gross Rental Income) – Operating Expenses
This will help the property investor account for a slight loss when computing NOI. You can also plug in different occupancy rates to see how they affect the cap rate and NOI. This will provide you with more realistic cap rates and expectations on the rate of return.
2. Depreciation
The cap rate gives you a picture of the property’s current profitability. However, future risks, such as depreciation, should also be accounted for. Remember that property values are unstable and may depreciate over time. Renovations and repairs could also impact the NOI.
3. Cash Flow Instability
Cap rates are helpful for properties that offer stable income. However, they can be less reliable if the property generates inconsistent cash flow. In this case, a discounted cash flow (DCF) model might be a better alternative to measure the rate of return. This method estimates the investment value by measuring its expected cash flow.
What’s a Good Cap Rate for Rental Property? Answered!
A good cap rate for rental property will depend on your risk appetite and goals as a property investor. The cap rate can be a fast way to gauge how well a property will do regarding profitability. Nonetheless, it’s also important to consider other factors before you invest in a property.
Do you need help managing your rental property? SurfRider Property Management provides premium services to Florida property owners. Call us today at 727-403-7088 or contact us online to learn more!