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Understanding cap rates

Whether it’s a short-term or long-term rental property, the same principle applies: cap rate (or, capitalization rate) remains a top metric by which to measure a real estate investment property’s profitability and return potential independent of that property’s financing method.

The Capitalization rate is the Net Operating Income (NOI) divided by the property asset value multiplied by 100 to achieve a percentage.

Why cap rates are important to real estate investors?

Cap rates are an important metric for real estate investors because they offer an accurate estimation of the profitability of a property. It allows investors to understand their return on investment and compare potential investments before deploying their capital.

Here are some of the reasons cap rates are critical for savvy real estate investors:

1. A more accurate understanding of operating costs
When it comes to operating a rental property, management and overhead costs can easily balloon out of control. Calculating the cap rate of a property allows you to understand all of the operating costs in detail.

Not only does this allow you to make the best decision about where to invest your money, but it also helps bring out-of-whack expenditures to your attention.

Decreasing your net operating income not only improves your cash flow and a cap rate but gives real estate investors the buffer they need to account for unexpected vacancies and capital expenditures down the road.

You may realize, for example, that the property has excessive energy costs because of an inefficient heating and cooling system. Examining your NOI early on enables you to identify changes you can make to increase profitability.

2. Helps in choosing between investment options
As an investor, there are many cases in which you may have several viable investment options available to you. At first glance, it may be overwhelming when trying to pick between the type of real estate investments.

  • Do you buy a single-family home?
  • A multi-family?
  • A new condo investment?
  • Deploy capital to an online turnkey platform?

Understanding the cap rates of all of these potential investment vehicles will enable you to make the best investment choice.

The cap rate can be a great indicator of which properties will yield the greatest return for your investment. It may come as a surprise just how much difference there is between two similarly priced properties when it comes to the annual rate of return.

How Do You Calculate Cap Rate?

To get a clearer idea of your potential property, follow the cap rate calculation formula:
Capitalization Rate = Net Operating Income / Property Asset Value X 100

This formula is right for you (and most real estate investors) if you assume that your NOI is the expected annual income from your short-term rental once you’ve accounted for all property management expenses. Be sure to include any taxes and other costs outside of just property management fees.

Also, remember that financing costs like debt services and your mortgage aren’t included in the formula. If you’re unsure of the exact cost of your future property, just sub the property asset value for your expected purchase price to get a broader estimate.

Cap Rate Example

If you purchase a property for $1,000,000 and your annual NOI is $100,000, your cap rate comes in at 10%: $100,000 / $1,000,000 = 10. Or, 10%.

Another way to calculate cap rate is by swapping the property asset value for purchase price:
Capitalization Rate = NOI / Purchase Price X 100

While some investors do use this formula, it has a few flaws. Because you’d in this case use older properties’ prices, you’re relying on prices that are too far in the past to give you an accurate estimate.

These prices will in almost all cases be significantly lower than current values and not present an accurate representation of your earning potential. It becomes even more problematic if you’ve inherited a property, which completely throws off the formula.

Whichever formula you use, remember that while the cap rate is great for getting a better understanding of your property’s earning potential, it should not be the only metric you use to determine that potential. It’s a good starting point, but you should also factor in future cash flows related to property upgrades, the time value of money, and other factors.

What is a Good Cap Rate for an Airbnb Investment Property?

Let’s revisit the 10% cap rate that we calculated earlier. Opinions on what constitutes a good cap rate vary as widely as the factors that go into calculating the rate but, overall, 10% is solid. Let’s look at the elements that go into determining just how solid a 10% cap rate is.

Cap Rates by City, Small Towns, and Destination Markets VaryNo two markets (let alone geographies) share the same conditions. Airbnb occupancy rates in destination markets ebb and flow depending on seasonality, while many urban markets see fewer fluctuations throughout the year. Those same destination markets also see revenue generation more dependent on specific amenities than those offered in urban and suburban listings.

Further splitting population centers’ ideal cap rates from destination and rural markets’ is the cost of the property. Broadly speaking, property costs more in cities than it does in more rural and destination markets, meaning that the cap rate in population centers will likely be lower than in more sparsely populated markets.

So, if you’re considering buying a property in Los Angeles don’t be too surprised if the cap rate is lower there than in Big Bear Lake, California, just 2.5 hours from the city.

Different Properties Influence Cap Rate

Airbnb has gained attention for many reasons over the years, but one of the booking platform’s biggest draws is that it enables hosts to offer a range of unique property types. From tiny homes to opulent mansions, yurts to condos, guests have more options than ever when it comes to booking their ideal stay.

The property type you offer your guests will greatly influence your cap rate. If you’re providing a single-family home, you may expect a lower cap rate than if you listed a multi-family unit depending on your market. Simply, more rooms generally mean more revenue potential which, of course, impacts Airbnb cap rates.

Cap Rates and Risk

No matter the market, there’s always a level of risk that comes with an Airbnb investment. A cap rate, above everything else, measures that risk. Broadly speaking, lower cap rates reveal lower risk, while higher cap rates show higher levels of risk.

However, a higher cap rate often indicates a more promising investment; higher cap rates are associated with higher rates of return. Still, lower cap rates don’t necessarily mean that a potential property won’t be a wise investment. Your purchase price, budget, location, and even neighborhood will impact your bottom line.

So, considering all the factors, what is a good cap rate? The answer is that it depends. And, depending on the source, a good cap rate hovers somewhere between 8% and 12%. But remember: this is just a range, and your percentage is not the only factor in determining whether taking on that investment is right for you.

Resources for Cap Rates

Knowing where to find some of these numbers can help you figure out what is a good investment or not. Check out Dynamic.RE to help you understand the market value, the rental rates, and even the Airbnb Annual Revenue.

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