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What is a good cap rate?

A good cap rate (capitalization rate) depends on a variety of factors, including the type of property, location, and market conditions.

Generalizing quite a bit, a cap rate of 7% or higher is considered a good cap rate. However, this can vary depending on the market conditions and the type of property. It's important to conduct thorough research and due diligence before making any investment decisions.

Very broad generalizations that vary by region, read on for a more nuanced answers:

Asset Class Cap Rate Range
Residential Rental 4% - 8%
Residential Multifamily 4% - 6%
Airbnb 8% or higher

Well, as many things in real estate and investing in general, it depends. A good cap rate in real estate mainly depends on geographical area in which the property is located and the cap rates on surrounding properties that are available. Additionally, regional and national average cap rates are also important to know to determine what is a good cap rate for the specific area and ultimately the property you are considering for the investment. This article will detail the step by step approach to gathering the necessary data, comparing it across correct dimensions for figure out what is a good cap rate for a specific property. Studies have shown that risk increase with 'reward' of higher cap rate, meaning the higher the cap rate of the property the higher the potential risk of the transaction. Given this information, its important to consider cap rate against other quantifiable metric such as historical occupancy rates, local population trends and similar factors that can de-risk the transaction. For each geographical location there is probably some ideal cap rate that is lower than the maximum cap rate for the region but carries a lot less risk then than the maximum cap rate property.

A good cap rate can vary depending on the type of property and location. For example, a commercial property located in a high-demand area may have a lower cap rate than a similar property in a less desirable location as well as relative levels of this cap rate might be significantly lower then a cap rate of a rental property because its a completely different asset class. In this article we will dive deeper on cap rate, its drawbacks and how its different across real estate asset classes.

Cap rate basics

Cap rate is short for "Capitalization Rate". Basic Capitalization Rate formula is

Capitalization Rate = Net Operating Income / Current Market Value

To understand this formula and its result we need to first understand Net Operating Income. Net Operating Income is the ultimate proceeds that are generated by the property and are calculated by the following formula:

Net Operating Income = Rental Income - Rental Expenses

The most important part of this formula is "Rental Expenses". If incorrect expenses are lumped into this category, the whole cap rate analysis will be thrown off. The correct expenses that must be included in the "Rental Expenses" as follows:

  1. Annual taxes. As they say, two certainties in this world are death and taxes. Taxes is one expense that always comes along with real estate property in US and can increase over time. Experienced real estate investors even project increases and pad this expense so their analysis can be more conservative letting them stay out of trouble. Doing small things like this is how they became experienced real estate investors versus failed real estate investors.
  2. Annual HOA. If your property is part of an HOA, this expense must be included.
  3. Annual utility expenses. If your tenants are responsible for paying this and its clearly stated on the lease, its ok to exclude this.
  4. Annual property management expenses. (even if you self-manage, you should include costs associated with providing these services, such as tenant search and rent remittence)/

Cap rate advanced

Down side of cap rate as a sole measure of property's attractiveness is that it does not capture the risk profile of the property. Studies have even shown that properties with highest cap rates in an area also carry the highest risk. The cap rate compensates you for higher risk of the property. Given this information, seeking maximum cap rate without weighting other factors that capture and quantify the risks of the property is short sighted and is not advisable.

One way to improve the cap rate metric for evaluation of a property is to add other factors that quantify risks of the property, such as:

Location: The location of the property is a crucial factor in determining the risk associated with the investment. Properties located in areas with high crime rates or poor economic conditions may be riskier than those in safer or more affluent neighborhoods. You can quantify neighborhood quality with a score to make comparison easier in your target geography.

  • Market conditions: The state of the real estate market, including supply and demand, vacancy rates, and pricing trends, can impact the potential return on investment and the level of risk associated with the property. This factor can also be quantified similar to how location is quantified, each neighborhood or zip has a rating 0-10 for its growth prospects during the hold period of your property.
  • Property condition: The physical condition of the property can impact the potential for maintenance and repair costs, as well as the potential for rental income. This information is already very conveniently quantified by the national association of appraisers and you need to get familiar with appraisal reports. Here is a breakdown of appraisal condition rating which should be used in your risk analysis of the deal.
  • Tenant quality: The quality of the tenants can impact the level of risk associated with the property. Properties with tenants who pay rent on time and maintain the property are less risky than those with tenants who are frequently late on payments or cause damage to the property.
  • Financing terms: The terms of the financing used to purchase the property can impact the level of risk associated with the investment. Properties with high levels of debt or adjustable rate mortgages may be riskier than those with low levels of debt or fixed-rate mortgages. This is one of the easiest things to add to your analysis of the investment opportunity. If you get online DSCR loan quote, without picking up the phone or sharing your email with us, we will show you the loan amount, interest rate and loan to value (LTV) that we can provide. This information should also be included in your analysis of the total cap rate. We can provide better terms for some properties then others so its important to get a quote for each property to receive accurate information.
  • Legal and regulatory factors: Legal and regulatory issues, such as zoning laws, building codes, and environmental regulations, can impact the potential return on investment and the level of risk associated with the property. Each zip or neighborhood can be rated their local political stability. Even HOA stability or hostility can sour a deal that looks attractive.

These factors can be quantified and be used as a 'risk weighting' for the cap rate to give you a more insightful ideal of how all the factors of the property are balanced against each other and how that compares to your other opportunities. The factors described above are generally applicable to all real estate however there are additional risk factors that are applicable to specific asset classes within real estate.

What is a good cap rate rental property?

As stated above, best we can do is a range and we aren't even sure how well it applies to your geography: 4% - 8%.

A good cap rate for a rental property can depend on several factors, such as location, type of property, condition of the property, and rental income. Generally (as generally as you can imagine), a cap rate of 8% or higher is considered a good cap rate for a rental property.

However, it's important to keep in mind that cap rates can vary depending on the local market conditions. For example, properties in highly desirable areas may have lower cap rates due to high demand and limited supply, while properties in less desirable areas may have higher cap rates due to higher perceived risk, so while income is great (on paper) you are running a significantly higher risk of remediation expenses that will significantly lower the cap rate in the future.

As discussed above, cap rate completely ignores risk, so high cap rate doesn't mean 'good'. It means, time to dig deeper and understand 'why' the cap rate is high for this property. A 'good' cap rate might be dead on the center of the market, if the property has other factors that lower future holding/ownership risk. One example is a building that has undergone a big renovation. This is captured in current cap rate (it drags it down), so the property looks less attractive right now. However, if you purchase this building, and lets say hold it for 30 years, but this exact repair is meant for 40+ years, you can expect not to pay it again during your ownership period, thus increasing the cap rate that you will ultimately receive.

Additionally, residential real estate has some unique risks and consideration, such as quality of local schools, entertainment options, access to transportation veins.

Considering a multitude of factors and even projecting some of these factors into the future will greatly improve your analytical approach to real estate.

What is a good cap rate for multifamily?

We have a range and we aren't even sure how well it applies to your geography: 4% - 6%.

In addition to points discussed above for residential rental real estate when it comes to cap rate analysis, multifamily is considered a completely different assets class within real estate and thus it has completely different benchmarks for the cap rate magnitude and volatility.

You analysis should also focus on the factors that uniquely influence the value of the multifamily property because those factors may be completely different from factors applicable to residential rentals, specially if your in strategically important locations with infrastructure or operations that current supports your properties tenants.

What is a good cap rate for airbnb?

We are even less sure for this figure then the rest of ranges stated for other asset classes because geography and tourist attractions play such as huge part of airbnb property's equation: 8% and above.

Unlike single family rentals, airbnb opportunities are highly sensitive to local tourist attractions that increase demand for short term stays at the property. This presents a nexus of risk from investors point of view. Lets say that stadium next door to your place is demolished in favor of a new one downtown, now no one is going to rent your place for airbnb for the big games. Thus airbnb properties with natural attractions are inherently more attractive such as beach properties, camping locations and ski resorts.

Seasonality is also a new risk factor that isn't present in the real estate classes discussed previously since most airbnb stays are not annual. If your property can only generate rent during a narrow window of time and operational issues prevent you from seizing that opportunity you are exposing yourself to a loss. An event such as this is impossible to capture in a metric such as cap rate, thus cap rate analysis is just a tip of an iceberg that must be investigated deeper in to truly understand if the property in front of you is a worthy investment.

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