What Is a “Good” Cap Rate For Short-Term Rental Property?
uncertainties when assessing returns and risks? As a seasoned luxury short-term rental (STR) investor with 18 properties under ownership, I know what it’s like to crunch numbers and pour over figures!
Fortunately, I’ve made it easy for investors – new and veteran, old and young – to not only understand these important measures of value but to maximize that investment value, over and over again.
Have you heard the term cap rate thrown around but don’t fully understand it? Are you tired of the 9-5 grind, choking debts, and limited free time, wishing there was a way to finally achieve your ideal life?
Luxury STRs make that possible! But first, you need to understand some of the lingo. Let’s cover everything you need to know about cap rates, and before you know it, you’ll be optimizing your passive revenue streams all over the place!
So What Is This All-Important Cap Rate, Anyway?
Cap rate, also known as capitalization rate, measures a property's profitability. It measures the relationship between the property's net operating income (NOI) and its market value. The formula for calculating your cap rate for rental property is as follows:
Cap Rate = Net Operating Income / Market Value
The net operating income is generated from the property minus all operating expenses, such as property taxes, maintenance costs, insurance, and management fees. The market value is the price the property would sell for in the current market.
Let’s Take A Closer Look at Cap Rates...
Suppose an investor is interested in purchasing a short-term rental property that generates $80,000 in annual rental income. The operating costs for the property include taxes, maintenance costs, insurance, and management fees, and a total of $40,000 per year. The investor can purchase the property for $800,000. To calculate the cap rate, we would use the following formula:
Cap Rate = ($80,000 - $40,000) / $800,000 = 0.05 or 5%
This means that the property has a cap rate of 5%. In other words, for every dollar the investor spends on the property, they can expect a 5% return on their investment.
Remember, cap rates represent annual percentages. So at 5%, you may expect to recoup your invested money in 20 years!
So, Is a Higher Cap Rate a Better Cap Rate?
I’m glad you asked. While an STR with a higher cap rate generates more money relative to its value, that doesn’t immediately mean it’s the right property for your goals. The first step is to assess your risk and reward goals.
Remember, luxury STRs typically have higher operating expenses than long-term rental properties. These expenses include cleaning fees, utilities, and advertising costs. Some put a good cap rate of 5% to 10%.
While a high cap rate may be enticing, it could indicate that the property isn’t in the most desirable location, leading to lower occupancy rates and higher tenant turnover. Furthermore, a high cap rate may be due to higher property expenses, such as maintenance or repair costs. These expenses could cut into the net operating income and reduce overall profitability.
Also, consider fluctuating market values, rental income levels, and interest rates. Although higher cap rates generally mean more risk and reward, and lower cap rates generally mean less risk and reward, the details are a little more complicated.
What Does Cap Rate NOT Tell Us?
In short, the capitalization rate is not an end-all-be-all of property performance. If your STR revenue is unstable over the long term, your cap rate may tell you very little. After all, it does not account for threats such as depreciation or structural changes in the market. Are you still unsure? Check out the 75 Most Profitable Cities to make your decision even easier!
Your interest rate, down payment, and loan lifetime are factors outside the cap rate calculation. Cap rates do not reflect any appreciation in property value or predict changes in property taxes. So, if taxes increase and your tenants become unruly, your cap rate may change significantly.
Recognize your cap rate for what it is and nothing more! It will help you evaluate your potential ROI, yes, but financing terms, property appreciation, expenses, trends, and tenant issues are critical too.
And don’t forget the type of property you own!
A Closer Look at Cap Rates By Property Type
As you purchase and rent out your luxury STR gems, remember the importance of property type. The property type also plays a significant role in determining a suitable cap rate for short-term rental properties. Vacation homes and luxury properties typically have higher cap rates than standard rental properties because they can command higher nightly rates. However, they also tend to have higher operating expenses, such as property management fees and maintenance costs.
Here is a comparison of cap rates for different short-term rental property types to help you make easy decisions.
Vacation homes are some of the most popular short-term rental properties (surprise!). They are usually located in hot tourist destinations and can range from condos to single-family homes. Because they are in high-demand locations, vacation homes generally have higher cap rates than other short-term rental properties.
According to industry data, the average cap rate for vacation homes is around 8%. A vacation home in a highly desirable location with a pool and other luxury amenities may have a cap rate of 10% or higher; a smaller vacation home in a less popular area may have a cap rate closer to 6%.
Urban Apartments and Condos
Urban apartments and condos are other popular types of short-term rental property. They are located in cities or tourist areas with high foot traffic. Because of their location, they may have higher occupancy rates than other types of short-term rental properties.
The cap rate for urban apartments and condos can vary depending on the location and property size. However, the average cap rate is usually around 6% to 8%, and higher in urban hub areas featuring major venues, parks, and gentrified areas.
Posh living – if only for a weekend – comes at a cost! High-end short-term rental properties offering first-class amenities and services frequently have a steep price tag. These luxury STRs can range from high-end apartments to mansions and villas. Regardless, their higher nightly rates typically result in higher cap rates.
Depending on where you look and the time of year, the cap rate for luxury properties fluctuates between 9% and 12%. A luxury property during the summer in a peak destination spot? You can expect to make more than a pretty penny off that!
Single-family homes are another type of short-term rental property that can overlap with luxury and vacation properties. Houses that are not particularly luxurious or well-located will typically have lower operating expenses than other types of short-term rental properties.
The cap rate for single-family homes can vary between 6% and 8%.
As you can see, your cap rate for rental property types varies by many factors and variables. Higher cap rates indicate a higher potential return on investment with higher risk or lower market demand. Conversely, a lower cap rate may indicate lower risk or higher market demand but may result in a lower return on investment.
But like I say, it always depends. When my students come to me with questions about cap rates, ROI, or any one of many metrics of performance, I always caution them. The most important thing, first and foremost, is your comfort level. Are you willing to take more risks for potentially greater rewards? Or would you prefer long-term stability with smaller returns?
With my AirDNA Workshop, you can nail down the perfect luxury STR that checks ALL the boxes.
Crunching the Numbers – How to Calculate Your Capitalization Rate
As a luxury short-term rental investor with a full-time job and family, the last thing you want is to be scratching your head over numbers.
This is why I can do it for you! I’ve helped countless students find, fund, acquire, market, and rent out their preferred rental properties for maximum revenue and profit.
Of course, why have me do it when you can learn it easily yourself and then replicate it whenever you want? My system is streamlined for a reason.
Not a numbers person? No worries, let’s go over how to calculate your capitalization rate in four simple steps.
The Quick Four-Step Formula for Cap Rates
As previously stated, the overall cap rate formula goes like this:
Cap Rate = Net Operating Income / Property Value
Now, let’s break this down further. The property's net operating income and market value require some calculations of their own.
Here are the steps to calculate the cap rate:
Step 1: Determine the property's gross rental income by multiplying the nightly rental rate by the number of nights rented in a year.
Gross Rental Income = Nightly Rental Rate x Number of Nights Rented in a Year
Step 2: Subtract the property's operating expenses from the gross rental income to determine the net operating income. Operating expenses include property taxes, maintenance costs, insurance, and management fees.
Net Operating Income = Gross Rental Income - Operating Expenses
Step 3: Determine the market value of the property. I can connect you with all the information you need, no problem!
Step 4: Divide the net operating income by the property value to calculate the cap rate.
Cap Rate = Net Operating Income / Property Value
With this formula, you can calculate the cap rate for a rental property to evaluate your investment potential. See, that wasn’t too bad, was it?
Find and Secure a Top Luxury STR With A Cap Rate Right For YOU
At the end of the day, what you want is clear. You want to reduce your stress. You want to expand your freedom. You want to create a lifestyle where passive revenue streams work in the background while you focus on what matters most: family, fun, and living life!
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Does it sound too good to be true? Truth be told, I never imagined that I would reach where I am, but here I am, and not only am I here, but I’m also bringing all my students, friends, and family along with me!
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And now I’m spreading the wealth. They say knowledge is power, and boy are they right. Take, for instance, one of my accomplished students, pharmacist Mason G. who just made his “first deal for 8 months at $4500 per month.”
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