Every real estate investor has one goal in mind which is to make money in real estate. How much money you make depends on many factors, one of which is your property’s rate of return on investment. There are two main real estate investment metrics that are used to calculate the return on investment which are cash on cash return and cap rate. Today our main focus will be on cap rate and what is cap rate in real estate.

What is cap rate in real estate?

As previously mentioned, the cap rate is a popular real estate metric used for measuring the rate of return on investment or the profitability for an investment property.

Additionally, the cap rate corresponds to the level of associated risks for an investment property, in theory. What does this mean? It means that low cap rates correspond to a lower level of associated risks and high cap rates correspond to a higher level of associated risks. Real estate investors who are familiar with cap rate know that the higher the cap rate, the better. But why would property investors prefer to invest in properties with higher associated risks? Well, lower risks yield low profitability, while higher risks yield high profitability! And what is the ultimate goal for every real estate investor? PROFITABILITY!

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Related: What Is Cap Rate in Real Estate Investing? A Simple Guide

What is cap rate in real estate vs. cash on cash return?

Many investors ask themselves the question “What is cap rate in real estate” since many tend to confuse it with cash on cash return. The cap rate measures the return on investment for an income property without taking into consideration the financing method used. In other words, cap rate does not depend on the property investors and is totally dependent on the income property. On the contrary, the cash on cash return metric analyzes and measures the profitability of an investment property and takes into account the financing method used which can be all cash or a mortgage loan.

Another factor that differentiates cap rate from cash on cash return is that the cash on cash return metric estimates the rate of return on investment only based on the rental income that the investment property will make in relation to the total cash invested by the real estate investor, not the value of the property.

Related: Cap Rate vs. Cash on Cash Return

What is cap rate in real estate? Factors that affect the cap rate

Cap rate not only differs from one investment property to another but also from one real estate market to another. There are factors that the cap rate depends on and that help determine the cap rate for each investment property. Let’s take a closer look.

What is cap rate in real estate? Factor #1: Location

Every real estate investor should know by now the importance of location in real estate. Location affects every aspect of real estate investments including the cap rate. An area in New York, for example, which would be a busy urban location will have a different cap rate from a rural area in Texas. Why, you ask? The profitability and return on investment for a certain investment property is determined by the demand and associated risks in a real estate market.

Read Also: Location Location Location: What Makes for the Best Place to Invest in Real Estate?

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What is cap rate in real estate? Factor #2: Property type

The second factor that determines the cap rate is the type of investment property. Is the property a single-family home or condo? Is it a multi-family complex or townhouse? The type of property affects the associated risks and thus the cap rate. How? Well, for example, multi-family homes rarely suffer from high vacancy rates. This means that multi-family homes have lower associated risks and could have a lower cap rate. On the contrary, single-family homes have higher associated risks since they face a higher chance of vacancy rates. These types of investment properties that have a high level of associated risks could yield higher cap rates.

It is important to keep in mind that the real estate investing market is constantly changing so saying that a certain type of investment property will yield a higher cap rate than another is a general statement. In some real estate markets, single-family homes are considered the more stable type of investment meaning it has lower associated risks and a lower cap rate.

What is cap rate in real estate? Factor #3: Interest rate

Interest rates in a real estate market affect the cap rate. When interest rates go up so do the cap rates. Why? Well as interest rates go up and debt services become more expensive, a real estate investor will have to pay less for an investment property in order to achieve a possible return on investment. In this situation, sellers will have to lower their prices and because of this, cap rates will go up.

What is cap rate in real estate? A final word

For those always wondering “what is cap rate in real estate”, here is a brief summary. Cap rate is a real estate investing metric used to measure a property’s return on investment. Cap rate does not take into account the investment property financing method which is what differentiates it from cash on cash return. There are many factors that affect the cap rate such as the location, the type of investment property and interest rates.

Finally, Mashvisor makes calculating cap rate easy and simple with our cap rate calculator which is part of our investment property calculator. This real estate investment tool allows you to estimate and analyzes cap rates of investment properties all over the US housing market. This helps you determine and identify the investment properties with the highest potential for profits.

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