In real estate, the cap rate is used to determine a property's potential and is calculated by dividing the NOI by the market value.
In real estate, Cap Rates are calculated by dividing your Net Operating Income (NOI), by the market value of a property. It can be used to determine an investment’s potential.
Your cap rate is a simple way to determine if a real estate investment has the potential to achieve your financial goals or not.
In real estate investing, the cap rate (capitalization rate) is a metric that is used to forecast the return on investment (ROI) of a property. It is calculated as a ratio of net income to capital costs or current value.
The cap rate then allows investors to determine how profitable an investment is going to be. Investors can use it to determine if a property they own is underperforming or whether it’s achieving its target and forecasted ROI.
There are a few simple steps to take to determine your property’s cap rate.
Step 1: Determine your annual net operating income (NOI).
To do this, you will need to estimate expected rent amounts and include any additional income sources, such as rented parking spaces, laundry facilities, etc. You can conduct a market analysis on similar rentals in the area to determine a realistic rent rate.
Once you have your gross income, you will need to deduct operating expenses (excluding mortgage payments). These expected operating expenses will include things like property management fees, homeowner association dues, taxes, insurance, and so forth.
For example, you are looking at a single-family home that you expect to rent for $1,800 per month. This would equal $21,600 annual gross income.
Your operating expenses might then equal 40% of that income, so $720 per month or $8,640 annually.
Your total operating income would then be $12,960 (before mortgage payments).
Step 2: Determine asset value.
There are a couple of ways to establish this. You can, for example, use Zillow Zestimates to get a rough idea of the current valuation of a property. Or you could contact your broker or an appraiser to get a more accurate idea of the property’s current market rate.
For this exercise, let’s say it’s a single-family home worth $250,000. Once you have this property valuation you’re ready to move on to the next step.
Step 3: Calculate your cap rate
To calculate your cap rate, you need to divide your net income by your asset value.
If we use the values in our example, that would be:
(12,960 / 250,000)x100 = 5.2%
We can use this simple formula to find properties with the best cap rates, which in turn, give us the best ROI.
It’s all very well to crunch the numbers and get your estimated cap rates. But if you don’t know what to look for, knowing what a good cap rate is and how to compare them is largely a pointless exercise.
Generally speaking, a higher cap rate is a riskier investment but is also likely a more profitable one.
It’s important to note that you can’t simply set a blanket target cap rate, as cap rates will vary broadly in different locations. As such, you should run a cap rate analysis on several other similar rental properties in the area to give yourself a benchmark.
The target cap rate you look for then, has to take into account key factors, such as location, demand, and economic stability of the area (for example, how available are jobs?).
Some investors won’t touch anything with a cap rate of less than 8%. Others aim for higher still, looking for double figures hoping to achieve a maximum ROI.
However, it depends as we say on how comfortable you are with risk, your long-term goals, and of course the location that you’re investing in. For example, if you wanted to invest in San Francisco you simply won’t achieve a 10% cap rate no matter how hard you look.
People who don’t want excessive risk but still want to achieve a respectable ROI will often look for a cap rate of between 4-6%. This range offers a reasonably good yield and enough stability for you not to feel nervous about potential cash flow issues.
Whatever your goals are, whether it’s simply to generate a little income on the side, to build a nest egg for retirement, or you want to build wealth and achieve financial freedom, the most important aspect is time.
The more time you’re managing your rentals the less time you have to scale, travel, or spend time with family and friends.
Modern real estate investors then are always looking for software and automation tools to help them gain control over their portfolios, save time, and improve operational efficiencies.
Landlord Studio, allows users to easily track income and expenses via their mobile device or desktop. Use time-saving features such as smart scan receipts which allows you to digitize receipts at the point of sale and the software automatically extracts the receipt data and creates the expense for you, and connects your bank feeds to view and reconcile transactions in real-time.
Additional features include online rent collection, which enables tenants to automate their rent payments. All income collected through online rent collection is automatically tracked in our income tracker. Automate tenant communications, set reminders for yourself, and more.
Every investor has different circumstances and goals and so you need to adapt your strategy accordingly. A good cap rate for some might not be so good for others. There are numerous determining factors to consider before you make an investment decision. The cap rate is only one metric that you can use to get a quick assessment of a prospective rental property.