What Is a Good Cap Rate for an Investment Property? (2024)

FAQs

What Is a Good Cap Rate for an Investment Property? ›

Market analysts say an ideal cap rate is between five and 10 percent; the exact number will depend on the property type and location. In comparison, a cap rate lower than five percent denotes lesser risk but a more extended period to recover an investment.

It's basically a mathematical formula used to calculate the ROI (Rate of Return) you'd expect to receive from a property you plan to purchase. Calculation Example: If the current market value of a property is $1 million and has an NOI (Net Operating Income) of $70,000, then the cap rate is 7% or 1,000,000 ÷ 70,000 = 7.

Average cap rates range from 4% to 10%. Generally, the higher the cap rate, the higher the risk. A cap rate above 7% may be perceived as a riskier investment, whereas a cap rate below 5% may be seen as a safer bet. If a property has a 10% cap rate, you should expect to recover your investment in about 10 years.

Investors hoping for deals with a lower purchase price may, therefore, want a high cap rate. Following this logic, a cap rate between four and ten percent may be considered a “good” investment. According to Rasti Nikolic, a financial consultant at Loan Advisor, “in general though, 5% to 10% rate is considered good.

It varies from investor to investor and property to property. In general, the higher the cap rate, the greater the risk and return.

Generally, a high capitalization rate will indicate a higher level of risk, while a lower capitalization rate indicates lower returns but lower risk. That said, many analysts consider a "good" cap rate to be around 5% to 10%, while a 4% cap rate indicates lower risk but a longer timeline to recoup an investment.

Overall, the higher the cap rate, the riskier the investment. That is, a high cap rate means your asset price is low, which typically points to a riskier investment. But you must compare to market cap rates in your area, as they can vary significantly. So, proceed with caution.

Market analysts say an ideal cap rate is between five and 10 percent; the exact number will depend on the property type and location. In comparison, a cap rate lower than five percent denotes lesser risk but a more extended period to recover an investment.

This is a general rule of thumb that determines a base level of rental income a rental property should generate. Following the 2% rule, an investor can expect to realize a gross yield from a rental property if the monthly rent is at least 2% of the purchase price.

Generally, a good ROI for rental property is considered to be around 8 to 12% or higher. However, many investors aim for even higher returns. It's important to remember that ROI isn't the only factor to consider while evaluating the profitability of a rental property investment.

Why is lower cap rate better? ›

It's generally better to have a lower cap rate than a higher one. A lower cap rate implies that the property is more valuable and less risky due to type, class, and market. While a higher cap rate offers investors a higher return, that property investment typically has a higher risk profile.

Historically, a good cap rate for multifamily is over 4% and could be as high as 10%. That range comes down to the fact that several factors can influence a good cap rate and possibly make a low cap rate look better or a good one look worse than it is. Interest rates are an important factor in assessing cap rates.

In Q1 2023, the average going-in cap rate, which is based on the first year of net operating income at the property purchase price, increased 23 basis points to 4.72%, “marking the first significant quarterly deceleration in cap rate expansion since the Fed began its latest round of rate hikes,” according to CBRE.

The disadvantage of using the cap rate for evaluating an income property is that it is challenging to determine the cap rate value for a sold property due to the difficulty of determining a sold property's operating expenses.

The interrelationship of NOI, cap rate and property value means that a property's value can be determined using the NOI and the cap rate — property value equals the NOI divided by the cap rate. A higher cap rate will therefore result in a lower property value, NOI being equal.

Higher borrowing costs

This is because the higher the cost of borrowing (brought upon by higher interest rates), the smaller the debt an income-generating property can service. This, logically, leads to a fall in property prices which increases cap rates.

2% Rule. The 2% rule is the same as the 1% rule – it just uses a different number. The 2% rule states that the monthly rent for an investment property should be equal to or no less than 2% of the purchase price. Here's an example of the 2% rule for a home with the purchase price of $150,000: $150,000 x 0.02 = $3,000.

If you purchase the property and hire a new property manager, over a short period of time you could increase your cap rate simply by raising the rent: Before rent increase: $6,000 NOI (with rents below market) / $100,000 market value = 6% After rent increase: $8,000 NOI (with rents at market) / $100,000 = 8%

A lower cap rate represents a less risky property, and an investor will be more willing to pay above the property value to receive a lower yield. On the other hand, investors can view a cap rate as a reflection of the price a real estate private equity (REPE) investor is willing to pay to purchase an income stream.

What is the cap rate of a REIT? ›

REIT Implied cap rates are generated by a proprietary calculation that divides a company's reported net operating income (“NOI”) adjusted for non-recurring items by the value of its equity and debt less the value of non-income producing assets.

Cap rate compression occurs when cap rates decline which, as valuations rise, which is a positive for REPE investors. In short, falling cap rates imply rising prices for a stream of income, an ideal scenario for commercial real estate investors, because it results in price appreciation and higher total returns.

Cap rates give investors a glance at the investment opportunity presented by a property. If the investment is offered at a 10% cap, you can expect to yield a 10% return; an 8% cap would yield an 8% return (both assuming you paid cash without financing).

Cap rates are measured as percentages, typically from 3-20%. This risk is measured based on the amount of time it takes for an investor to recover their initial investment. When a cap rate is low, the property has a relatively higher value and lower risk.

Assuming that the average capitalization rate of the market in which this property is located is 18%. The investor can conclude that a 20% CAP rate means the property is overperforming the market by 2%. Based on the property's market value, the investor is generating 20% of his property's value per year.

What Is The 50% Rule? The 50% rule is a guideline used by real estate investors to estimate the profitability of a given rental unit. As the name suggests, the rule involves subtracting 50 percent of a property's monthly rental income when calculating its potential profits.

The cap rate of a property is determined based on the potential revenue and the risk level as compared to other properties. Importantly, the cap rate will not provide a total return on investment. Instead, it will indicate an estimate of how long it will take to recover the initial investment in the property.

At face value, inflation can increase cap rates, thus driving down commercial real estate valuations. But, inflation also tends to drive NOI higher, which can have an offsetting effect on these decreased valuations.

Every year, as you finalize your building's annual net operating income, your cap rate calculations should change. Rent will change based on your lease terms and if there is any vacancy.

If the cap rate is greater than the interest rate, you'll generally come out ahead. If the cap rate is lower than the interest rate, you'll be relying on appreciation for your return, making it a riskier speculative investment.

What is the relationship between cap rates and mortgage rates? ›

Capitalization rate is the ratio of net operating income to property price. Mortgage interest rate indicates the cost of debt. Commercial mortgage lenders have noticed that the spread of capitalization rate over mortgage interest rate influences mortgage demand.

The interrelationship of NOI, cap rate and property value means that a property's value can be determined using the NOI and the cap rate — property value equals the NOI divided by the cap rate. A higher cap rate will therefore result in a lower property value, NOI being equal.

Calculating a Cap Rate in Commercial Real Estate

If you invested $1,000,000 in a property, with a 6% CAP rate, you would receive $60,000, at year-end.

Cap rates are calculated by dividing the property's net operating income (NOI) by its property asset value. Cap rates can provide valuable insight into a property. But the cap rate is not the only metric used to evaluate a real estate investment.

Meaning of Cap Rate Compression

Cap rate compression is the opposite of expansion, it is when cap rates fall. Lower cap rates mean higher property prices, which is a positive for real estate investors because higher property valuations are correlated with higher returns.

Higher borrowing costs

This is because the higher the cost of borrowing (brought upon by higher interest rates), the smaller the debt an income-generating property can service. This, logically, leads to a fall in property prices which increases cap rates.

If you purchase the property and hire a new property manager, over a short period of time you could increase your cap rate simply by raising the rent: Before rent increase: $6,000 NOI (with rents below market) / $100,000 market value = 6% After rent increase: $8,000 NOI (with rents at market) / $100,000 = 8%

A good cap rate can be anything between 4%-12%. If you are in a location with high demand and high costs like New York City or Los Angeles 4% may be considered a good cap rate. A lower-demand area like an area that is developing or a rural neighborhood might see average cap rates of 10 percent or higher.

Cap rates give investors a glance at the investment opportunity presented by a property. If the investment is offered at a 10% cap, you can expect to yield a 10% return; an 8% cap would yield an 8% return (both assuming you paid cash without financing).

Remember that the best cap rate value is between 8% and 12% to balance between ROI and risk. Second, savvy investors use the cap rate to find the best deals for sale. Just as you can use this measure to compare between markets, you can use it to compare between properties.

What is a realistic cap rate? ›

Market analysts say an ideal cap rate is between five and 10 percent; the exact number will depend on the property type and location. In comparison, a cap rate lower than five percent denotes lesser risk but a more extended period to recover an investment.

There is no specific rule of thumb for those wondering what constitutes a good return rate. There seems to be a consensus amongst investors that a projected cash on cash return between 8 to 12 percent indicates a worthwhile investment.