Investing in real estate is a bit more than just buying a property and renting it out. Although it can be quite lucrative, you have to do some math first. That’s where calculating the cap rate comes in.
Before investing in in a rental property, the math simply has to make sense. Your pride and joy could end up being a complete money pit and can lose you money from day one.
That’s why calculating the cap rate for a rental property is crucial. This formula will help you determine if the investment you are about to make is profitable or not.
What is a Cap Rate?
The Cap Rate (or Capitalization Rate) is used in the world of real estate to determine the rate of return that an investment property it’s expected to have. The cap rate is calculated by dividing the net operating income by the current market value.
Although the cap rate is extremely useful in determining the viability of an investment property, it shouldn’t be used as the only indicator. When it comes to real estate Investments, there is no one shoe fits all value.
Cap Rate Formula
Now that you have a bit of an understanding of what the cap rate is, how exactly do you even calculate it? Several versions of this formula exist, but we will talk about the most popular one today.
As mentioned above, when calculating the Cap Rate we use just two numbers. The cap rate is calculated by dividing the net operating income by the current market value.
Capitalization Rate = Net Operating Income / Current Market Value
- Net Operating Income: This is the expected annual income the rental property is expected to generate. You calculate this by subtracting all expenses incurred by the property (like taxes, mortgage, maintenance, etc) from all rental money received.
- Current Market Value: This is what the home, building, or apartment complex is worth this present-day.
A slightly different version of this formula is as follows:
Capitalization Rate = Net Operating Income / Purchase Price
- The only difference here is that, instead of using the market value of the home, you use the exact dollar amount of what you are going to pay for the home.
Cap Rate Calculator
If you already have the numbers on hand, then calculating the cap rate is pretty easy. You can use our handy cap rate calculator tool below.
Simply enter your net operating income and the market price or value of the property you want to purchase. You can’t preach will be automatically calculated for you. Give it a go, it’s completely free.
Importance of Cap Rates
If you are at all interested in owning rental properties, cap rates are going to be a very important metric. They offer an accurate estimation of how profitable a property is.
Instead of jumping in headfirst and buying a property without understanding its profitability is a recipe for disaster. By calculating the Cap Rate, it gives you the opportunity to understand the profitability and allows you to compare different investments before purchase.
Here are a few advantages of using cap rates when assessing rental properties:
Say you had an option between two properties to invest in. They are located in the same neighborhood, and maybe even a few streets from each other. Apart from how they look, how do you make an informed financial decision?
By using the cap rates, properties that are in the same area and similar conditions can be compared using this formula. If you notice there’s a difference in cap rates for these two properties, it could be due to several reasons:
- Mismanagement of the property, resulting in lower returns
- Under-renting, resulting in lower occupancy rates
- Potential for value-add opportunities, earning you more
Analyze Potential Returns
By definition, this capitalization rate can give you an accurate representation of how much you can expect to earn from a property. This is due to how the formula itself is built.
The formula accounts for all income and all expenses you expect to incur. By taking these two very important numbers into consideration, it is an excellent way to fully understand and analyze potential returns that a property has.
Analyze The Market
The cap rate of an area can be a good indicator off the strength of that particular Market. By simply going online and checking out how much properties are renting out for in an area, the cap rates can be a good tool in your arsenal.
The lower the cap rate, the stronger that market is. This shows that properties are in high demand. You can often see this in large cities like Los Angeles and New York City.
Cap Rate Example for a Rental property
At this point, you probably have a pretty good understanding of the cap rate. How about you look at an example, so you can see the formula in action.
Let’s imagine that a rental property is being sold for $150,000. The monthly rent for this property will be about $1,000 per month ($12,000 a year). Now, let’s account for expenses that’s this property will incur:
- Property Taxes: $60
- Insurance: $45
- HOA Fees$ 60
- Property Management: $80
- Maintenance: $100
These are your monthly expenses. Now if we subtract $345 from the rental earnings of $1,000 we will have $655 Net Monthly Operating Income. We then simply multiply that by 12 months to get $7,860 Net Yearly Income.
So far so good.
Now, using our handy dandy formula, we can then figure out our Cap rate:
$7,860 / $100,000 = 0.078
With this example, the Cap Rate is 7.8%! Voila. With quick simple math, calculating the Cap Rate is easier than it might seem. You will have a pretty good idea of the return on investment of this rental property.
What is a good Cap Rate?
Figuring out what a good cap rate can be a bit difficult. A good cap rate is typically determined by the markets that you are in. A good cap rate for San Francisco California is very different from a good cap rate in Kansas City Missouri.
For a general rule of thumb, here are the average Cap Rates that most real estate investors aim for in Urban Areas:
|Type of Property||Average Cap Rate|
|Single Family Home||6.50%|
Remember, these are simply averages. Your real estate goals, area, and property type all play a part in figuring out a good cap rate. This will already depend on you and your financial goals.
When it comes to calculating and using the Cap rate, it is important to remember that they should not be used as the sole determining Factor when evaluating a property.
Take a break can be a good starting point and a good indicator of profitability, but other just as important factors play a part in any decision-making.
You might also want to take into consideration the property location, your financial goals, the property type, amongst all their various things you might find important.
There is no single metric that will give you all the information you need when deciding on investing in a property. You should absolutely use all the tools that you have access to you and evaluate your own personal goals.
Hope you find this article insightful and helpful in your financial journey! Any questions, leave them below! 🙂