Looking for a property for sale that will provide you with profits as a real estate investment? Then you need to learn about the cap rate calculation.  

So, you’ve learned the many benefits of investing in real estate and decided to buy your first rental property. Not so fast! Just because there’s money to be made in real estate, not every piece of real estate is profitable. Some investment properties will even cost you more than they’ll make you. You don’t want to end up in that situation right? This is why the most important aspect of real estate investing that beginner investors must learn before jumping into the industry is how to analyze investment opportunities.

Basically, this is the process of running the numbers behind a potential real estate investment early on to tell you if this deal has promise or not. There’s a number of metrics or calculations that property investors use for analyzing rental properties, the most common of which is the cap rate calculation. In this guide for beginner investors, we’ll explain what the cap rate is, why it’s important, and how to calculate it. Let’s get started!

Related: What Are the Most Important Metrics in Real Estate Investment Property Analysis?

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First Things First: What’s Cap Rate in Real Estate?

The cap rate (aka capitalization rate) is commonly used in real estate to refer to the rate of return on a rental property. It is based on the net operating income (NOI) that the property generates in relation to its current market value. A real estate investor can use the cap rate calculation to either analyze a certain deal or to compare different investment opportunities. For example, if all else is equal, an investor is most likely to buy a property with a 10% cap rate versus another with 3% cap rate.

In addition, the cap rate is also understood as a measure of risk in real estate investing. So, a higher cap rate tells property investors that the investment is riskier and a lower cap rate means an investment is less risky. Keep in mind that this is the same principle that gives you a lower return on investment for low-risk assets than for more risky assets. Meaning, while high cap rate properties can be riskier, they also give a higher return on investment. Of course, this theory varies depending on the type of property you’re looking at, its location as well as its condition.

But as a real estate investor, you shouldn’t just pay attention to the potential returns or profit from the rental property. You also have to estimate and protect yourself against the possibility of losing money (risk). This is another reason why the cap rate calculation is great for analyzing real estate opportunities as it enables you to make investment decisions more confidently when you balance risks and rewards.

Mashvisor helps you find the best investment properties for sale with the cap rates that match your criteria in a matter of minutes! To start looking for and analyzing the best investment properties in your city and neighborhood of choice, click here.

So, What’s the Cap Rate Calculation?

As mentioned, the cap rate is the ratio of a rental property’s net operating income to its market value. If you’re not familiar with the NOI, it’s simply your annual rental income generated by the property minus all operating expenses including management, taxes, vacancy, insurance, repairs, HOA costs, etc.

It’s important to note that the cap rate calculation does NOT take the financing costs into account. This is because NOI does not include mortgage payments or interest payments. Excluding debt is part of why the cap rate is so useful to real estate investors. The assumption that the investment property is bought in cash lets you focus on the property itself and its profitability instead of being distracted by debt and financing. This also lets you better compare the risk of one property (or market) to another.

Example of How to Calculate Cap Rate

You’re a real estate investor looking to buy a rental property. You’ve saved up enough cash as you plan to buy the investment property without taking out a mortgage. From reading this blog, you remember that the cap rate calculation is an effective metric for evaluating the profitability of rental properties. After searching in your local market, you’ve found three properties for sale with their respective expenses, annual rental income, and market values:

After doing the calculations for the rental properties above, you realize that Property C returns the highest cap rate.

Related: What’s a Good Cap Rate for Investment Properties?

You can use our Investment Property Calculator to find the cap rate of different rental properties readily calculated in your city of choice! Start out your 14-day free trial with Mashvisor to give it a try.

Factors Affecting Cap Rates in Real Estate

To decide if you’re getting a good cap rate and judge the risk of the real estate investment, you need to understand the three major factors that affect the cap rates of rental properties:

#1 Economics and Demographics

The cap rate is different in different cities and locations. Let’s say you want to buy an investment property in a major city like San Francisco. It’s a big city with a strong economy and has a high rental demand. At the same time, it has a lack of new supply because of land shortage and regulatory restrictions. These economic and demographic factors affect real estate values (i.e. higher property prices). For this reason, rental properties in San Francisco have low cap rates, so investing here is less risky. This means that real estate investors should be willing to accept lower returns because of the lower perceived risk.

On the other hand, the economic and demographic fundamentals of a small town housing market are different. These locations are economically not as strong as major cities that have diversified economies. Therefore, real estate investors will need to find properties with higher cap rates to compensate for the higher risk. This also tells you that you should not use the cap rate calculation to compare rental properties in different locations!

Interested in learning the cap rates of major cities across the US housing market? Read 2019 Cap Rates by City: What Real Estate Investors Should Expect

#2 Local Real Estate Market

Cap rates are not just different between cities, but also between neighborhoods within a city. Remember, real estate is very local. For example, consider analyzing two properties in different neighborhoods – one is highly desired and has demand for rentals while the other is a run-down part of the city. You’ll notice that investment properties in the run-down part of the city have a higher cap rate, reflected by lower market values. On the other hand, a property located in the desired neighborhood would have a lower cap rate – reflected by higher market values. That doesn’t make it a bad place to invest in real estate! It’s only a matter of understanding risks and figuring out how to address them.

#3 Type of Investment Property

Finally, to determine if you’re getting a good cap rate, you also need to account for the type of real estate property you’re investing in. For example, the cap rate calculation will have lower results for a residential real estate asset than a commercial one in the same location. Likewise, multifamily homes are known to have lower cap rates than single-family home rentals. What’s the difference? Again, it all goes back to risk.

During a recession, a retail shop might go out of business, but people will still need to live somewhere. Meaning, the residential rental property will likely remain occupied and generate income even if rental rates are lower. The owner of the retail shop, however, could face long vacancies. Thus, residential properties provide lower cap rates because they have lower risks.

Moreover, even residential property types have different cap rates. For example, multifamily homes and apartment buildings will generate rental income from numerous tenants even if one tenant didn’t pay the rent for the month. However, if you’re investing in a luxurious single-family home and your tenant didn’t pay the rent, you’ll be left with no rental income that month to cover your expenses. Higher risk = higher cap rate. This is why investors should use the cap rate calculation to compare real estate properties of the same type!

How to Find High Cap Rate Properties for Sale

Want an easy way to find profitable investment properties for sale in the US housing market without doing the cap rate calculation? Mashvisor’s Property Finder allows you to do just that! With this tool, you simply customize your search criteria through setting filters including your:

CityBudgetPreferred Rental Strategy (Traditional or Airbnb)Type of Investment PropertyNumber of Bedrooms and Bathrooms

From there, the Property Finder Tool will give you a list of the highest cap rate properties for sale in your selected city. And, after you’ve selected a few potential properties, you can use the Investment Property Calculator to do a full property analysis to make sure you’ll get a good return on investment!

Do you have a free Mashvisor account? Use our Property Finder to find lucrative investment properties that match your criteria in a matter of minutes!

Final Note on the Cap Rate Calculation

While the cap rate is important for analyzing and comparing real estate investment opportunities, it’s only one of many metrics to find the rate of return. So, property investors should use the cap rate calculation together with others (like the gross rent multiplier and cash on cash return) to ensure making the right investment decisions. To learn more about these, keep reading our real estate investment blog – it’ll teach you everything you need to start your real estate investing career!

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