You hae certainly heard about the term “CAP rate.” The value of a rental property lays in its profitability. Therefore, the capitalization rate (also known as CAP rate) is an extremely important tool for real estate investors. It represents the ratio of the property’s net income in comparison to its purchase price. In other words, how much – and how fast – the investors can hope to get their money back. It can help them decide whether or not the rental properties they are considering purchasing represent an interesting investment as well as which one would be the best investment. Therefore, you should always calculate the capitalization rate of any rental building you may be interested in purchasing.
Here is everything you should know about the CAP rate in order to invest wisely in rental properties.
The CAP rate is calculated by dividing the Net Operating Income (NOI) of the property by its value.
- How to calculate the CAP rate of rental properties?
The first step is to calculate the yearly gross income of the rental property you are considering. The main source of revenue is the rent originated from the tenants. However, there may be other sources of income such as coin operated vending or washing machines, etc.
From the number obtained, subtract the operating costs associated to the property. It can include maintenance costs, insurance, taxes, utilities, vacancy costs, and property management costs, HELOCS, etc. The mortgage amount, however, is not part of the expenses. The more accurate these numbers are, the most reliable the capitalization rate of your rental properties will be. You can usually obtain theses numbers from the listing agent or by experience. You may also include the property’s vacancy rate. The resulting number is the Net Operating Income.
The CAP rate is expressed as a percentage.
The formula to calculate the CAP rate is the following:
NOI/Purchase Price = CAP rate
- How to use the CAP rate?
The CAP rate has many different uses. Generally, the higher the capitalization rate is, the more profitable the investment property may be. It is a quick and fairly convenient way to judge the potential of a rental property.
It allows potential investors to compare different buildings in order to decide which one may have the best return on investment (ROI). However, it can only be used to compared similar properties.
If you can get a hold of the costs and rental amounts for previous years, the CAP rate is also a great way to identify the trends and potential issues an investor may encounter on the local market.
It should be noted that what constitutes a good CAP rate for a rental property is highly location dependent. 10% or more is considered optimal. However, a good capitalization rate in a large city is very different than the one you would get in a more rural area, for example. Therefore, you should familiarize yourself with the local market before making a decision on whether or not the investment property is “worth it”.
For these reasons, the capitalization rate should not be the only tool a wise real estate investor will use when evaluating an income property. It should be used in correlation with other real estate valuation methods, such as the Gross Rental Multiplier (GRM) or cash-on-cash return.