What Is the Cap Rate and Why Is It Important?

Capitalization rate (also known as cap rate) is the rate of return on a commercial real estate investment.

While cap rate does not consider the impact of mortgage financing, a general rule of thumb is whether the cap rate is above or below the interest rate. 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.

How to calculate cap rate

The formula for cap rate is simple: income, fewer expenses, divided by the purchase price.

On a long-term rental, multiply the monthly rental rate by the number of months per year you expect the property to be rented. In areas with healthy rental markets, 11.5 months is usually a good rule of thumb, as that assumes the property will be vacant for one month every two years.

How do you estimate rental earning potential when determining cap rate?

To estimate income for a vacation rental, Northern Michigan Escapes offers a vacation rental income calculator that analyzes millions of data points about the market and specific vacation home you’re considering. We compare the home to similar properties with similar appeal to create a custom income estimate—an idea of how much the home could earn as a Northern Michigan Escapes vacation rental.

After estimating your earning potential, the next step in figuring cap rate is to subtract your anticipated annual rental expenses and operating costs.

Cashflow analysis

Sample cap rate calculation

How do you estimate vacation rental expenses and operating costs when determining cap rate?

A home with low expenses and operating costs in a high-demand market is likely to have a good cap rate. Expenses and operating costs will vary depending on a variety of factors, including location, the type of property you buy, and the method of property management you prefer.

When estimating your anticipated rental expenses, don’t forget to factor in seasonal services that the property may require. For example, a four-bedroom beach house on the Gulf Coast may require additional maintenance due to wind, sand, and salt, whereas a four-bedroom cabin in Keystone, Colorado, may need regular snow shoveling or fallen tree removal.

Take the time to figure utilities and taxes for each property when determining your expenses in vacation rental markets. Sometimes finding a better cap rate is as simple as searching for homes in lower-tax neighborhoods that still hold appeal for guests.

If you plan to host guests on a regular basis in your vacation home, you should expect a bit of wear and tear. Factoring in things like maintenance, replacement, and repair costs, you should budget around 5–10 percent of your net rental income to cover updates. You can then factor in your mortgage.

The most variable expense to consider when determining cap rate is property management. If you plan to self-manage, you will need to account for everything from cleaning, maintenance, supplies, and marketing to guest support, accounting, and insurance. Or you can use an end-to-end vacation rental property management service from Northern Michigan Escapes.

Working with full-service property managers such as Northern Michigan Escapes not only means someone else is doing all of this work for you, it also consolidates all of your property management expenses so that you can more easily factor cap rate.

Is a higher or lower cap rate better?

Bigger is generally better when it comes to cap rate—but it’s not everything. If you’re deciding between a vacation rental property with a six percent cap rate and another with a two percent cap rate, you’ll get a higher return on investment with the six percent property. But there’s more to think about.

Cap rate doesn’t include things like potential equity growth or emotional value such as locking in a dream home for your retirement. Sometimes a home with a slightly lower cap rate is simply a better fit for you and your family.

What is a good cap rate for rental property?

Due to differing rental demand and home prices, what you’ll consider a good cap rate will vary based on the market. For example, in Moosehead Lake, Maine, you might be negotiating for five percent to eight percent cap rates, whereas in Park City, Utah, you may be happy comparing properties in the three percent to five percent cap rate range.

Does cap rate take into account appreciation?

Cap rate doesn’t consider the benefits of potential appreciation. As a shortcut, you can add the anticipated appreciation to your cap rate to estimate your total return. A 5% cap rate and 5% appreciation gives a total return of 10%, comparing favorably to current interest rates and long-term stock market returns.

How is cap rate used in real estate?

Consider this example:

The Smith family wants to buy a four-bedroom vacation rental property near the beach. After speaking to property managers, they've determined the average operating cost for two four-bedroom townhomes in the neighborhood they want to buy.

Vacation home #1 is beachfront but in poor condition. The Smiths estimate they would need to invest about $100,000 into the home to make it vacation-rental ready. The home is on the market for $540,000 and the Smiths expect it to generate $40,000/year after operating costs. That's a cap rate of 6.2 percent ($40,000/$640,000).

Vacation home #2 is two blocks from the beach but features modern design and a hot tub. It costs $553,000 and is expected to generate $40,000 after operating costs. That's a cap rate of 7.2 percent.

Comparing cap rates alone, the Smith family sees that even though vacation home #2 is more expensive, it could provide them a better return on their investment. But that isn't their only consideration.

They could leverage the work that house #1 needs to negotiate a better price. For example, let’s say they’re able to negotiate the price of the sale down $100,000 to account for the $100,000 of upgrades they need to do. With the home price now at $440,000, their cap rate jumps to 7.4 percent ($40,000/$540,000), much closer to the earning potential of house #1.

To improve their cap rate for home #1 even further, they could transform the unfinished basement into another room for $10,000, bringing the earning potential of the home up from $40,000/year to $60,000/year. Factoring the additional construction cost for the new room into the home price means they’ll be investing a total of $550,000. But with the increased earning potential, their cap rate becomes 10.9 percent ($60,000/$550,000)—their best option so far.

If they can’t negotiate, the Smiths will have to figure value beyond cap rate. For example, does owning beachfront property where they may someday retire warrant buying a home with slightly lower earning potential on the rental market?

Can you find market cap rates for vacation rentals?

We compile market cap rates to help vacation rental property buyers find the markets that are delivering the best returns on investment. Knowing what a cap rate is and why it’s important will help you make a more informed decision when buying a vacation rental. For other tips on buying a vacation rental, see our lifestyle real estate page.

What is cash-on-cash return?

A related metric that considers mortgage financing is cash-on-cash return, which compares cash flows, less financing expenses, with the down payment. As cash-on-cash returns just consider the difference between the income and the mortgage against the down payment, they can be extremely sensitive to variations in performance.

For example:

$600,000 purchase price
$100,000 down payment
$1,800 monthly mortgage payment

Cap rate vs. cash-on-cash return

"We'd like to help you understand what a cap rate is and why it's important. Send us a message or give us a call at 231.242.3722 to learn more today."

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