(This advanced blog summarizes real estate investing tips and insights Lofty AI has acquired from working with thousands of investors and institutional funds.)
What is a good cap rate?
In general, a property with an 8% to 12% cap rate is considered a good cap rate.
The first factor is location.
For example, a 4 percent cap rate may be the norm in high-demand, high-cost areas like New York City or Los Angeles.
In contrast, a lower-demand area like an up-and-coming neighborhood or a rural neighborhood might see average cap rates of 10 percent or higher.
Other parameters that affect what is considered to be a good cap rate include:
- Current rental income of the property
- Rent pro forma (future forecast of rent)
- Risk tolerance
- Future property appreciation
We're going to look at these factors in a bit more detail. But first, let's define what a cap rate is and give a brief example.
If you already know this, feel free to skip past this next section.
What is cap rate?
What is cap rate in real estate? Cap rate, or capitalization rate, is an ROI calculation used to compare similar real estate investments.
The cap rate is the rate of return you can expect on your investment based on how much income you believe the property will generate for you.
The higher the cap rate, the better.
Cap rate formula:
Cap Rate = NOI/Purchase Price × 100%
Net operating income (NOI) is the annual income generated by the property after deducting all operational expenses.
This includes both property management fees and taxes.
Cap rate example
You can run a calculation for the cap rate by using the net operating incomes and recent sales prices of comparable properties.
The cap rate is determined and then applied to the property you're considering purchasing. This helps to determine its current market value based on income.
Below is an example of a calculation for cap rate for three different properties:
- Property A - On the market for $750,000, has an annual income of $85,000 and annual expenses of $50,000
- Property B - On the market for $700,000, has an annual income of $75,000 and annual expenses of $35,000
- Property C - On the market for $1,000,000, has an annual income of $130,000 and annual expenses of $60,000
Which factors influence a good cap rate
This next part is a continuation of the introductory section.
There are many factors that influence what a good cap rate is.
Remember, just because you buy a property that has a good cap rate initially, doesn't mean it's going to perform well in the future.
Current rental income of the property
The current rental income of a property determines its cap rate.
Cap Rate = NOI/Purchase Price × 100%
Ideally you want the rent to be as high as possible when you first buy the property, which will cause the NOI to increase giving you a higher cap rate. Remember, the NOI is calculated by subtracting operating expenses from the total revenues of a property.
The issue with most investors is that they'll only look at the rental income at its present value.
What you want to do instead is determine the cap rate once you add value to the property. This could mean replacing roofs, mowing the lawn, or any other work which helps to increase rents. When rents increase, so does the cap rate.
Rent pro forma
Unless you're buying class A properties, you will most likely be doing work on your properties. Once the value-add work is complete, the goal is to be able to both charge higher rents and reduce your vacancy rate.
To predict what rent and vacancy rates will be in the future, investors will use a rent pro forma.
A rent pro forma is a detailed break down of the income and expenses of a rental property once it is fully stabilized and operating at peak efficiency.
Peak efficiency means that it has the market rents, income, vacancy rates, and operating costs compared to other properties with a similar class and age in that market.
Like most ROI calculations, determining what is "good" has a lot to do with your risk tolerance.
To further explain, let’s take a look at two investments, one that’s a 5% cap and one that’s a 7% cap rate.
The property with a 5% cap rate may be a good fit for an investor looking for more of a passive and stable investment. It might be in a better location currently, but has a lower chance of rapid future appreciation.
The property with the 7% cap rate is a better fit for an investor that’s willing to take more of risk. But with risk, often comes reward. Though less stable, this property will have higher upside potential for appreciation.
Future appreciation and gentrification
Some real estate investors consider appreciation a "nice to have" compared to cash flow. This is due to the fact that it's simple to project cash flow. But it's extremely difficult to predict appreciation.
Throughout history, predicting appreciation has always been a guessing game. Luckily, there are tools today which make predicting appreciation accurately, possible. For example, Lofty AI uses artificial intelligence and real-time social data to accurately predict appreciation down at the block level.
Let's say you buy a property with 5% cap rate and another property with a 10% cap rate. Right off the bat, the 10% cap rate property is doing much better. It's generating more revenue and is in a more stable neighborhood. But, what if the 5% cap rate property was in Williamsburg, NY 10 years ago? Or The Arts District in Los Angeles 7 years ago?
Property prices literally doubled in value within a 2 year period in both of those markets. The 5% difference cap rate is negligible when you take into account returns you'd get by owning a property in one of those neighborhoods.
Why is cap rate important?
The cap rate is an important ROI calculation for many reasons:
- Determine profitability - Cap rate is the best ROI method to determine if a property is immediately profitable. This is because it's comparing the income you're receiving to the actual price you're paying for the property.
- Compare investment properties - Cap rate is a great tool to compare investment properties at their current state. This is helpful if you have three properties right next to each other, of a similar property type, and are all the same price. Whichever property is generating the most income will have the highest cap rate, and will be the obvious decision which property to buy.
- Estimate the payback period - Cap rate is helpful to quickly calculate a payback period for an investment property. To calculate the payback period, you'd divide 100 by the cap rate. For a property whose cap rate is 10%, for example, you'd be looking at a 10-year payback period.
Lofty AI’s cap rate calculator
This calculator works on any of our A.I.'s approved properties -- both traditional and short-term rental properties.
You're able to adjust the loan duration, mortgage APR, purchase price, down payment, operating expenses, rent, vacancy rate, and much more.
Alongside our calculator, our app is constantly finding properties that are undervalued and located within neighborhoods primed for rapid appreciation. This makes real estate investing online extremely simple.
In January 2019, our A.I. chose 639 properties in 20 different markets based on our models parameters. Fast forward 12 months later and the average returns purely based on appreciation were 58%.
That’s over 22X more than the market average appreciation without cash flow factored into the equation.
If you’re interested in learning more, click the button below to request access.