Capitalization rates (cap rates) are a tool for investors to get a rough value of a property based on its net operating income. If a real estate investment offers $160,000 annually in net operating income and comparable properties have sold based on 8% capitalization rates, the property can then be roughly valued at $2,000,000 ($160,000 divided by 8%).
What is a Cap Rate?
Cap rate = Annual income/Total value
While it won't be the only factor in a real estate investment, the capitalization rate is a good starting point to easily compare opportunities.
Comparatively low cap rates indicate less risk, such as increasing demand, while higher cap rates may indicate more risk. Assessing risk requires analyzing several factors, including lease term, property location, creditworthiness of tenant and market volatility.
Is the Property Worth it?
The cap rate is just one financial tool real estate investors use to make a smart decision. On the other hand, many people who are just starting out in the industry, perhaps searching for a single-family home in which to invest, often rely more on emotion to make a purchase decision. Unfortunately, too many simply fall in love with a home and hope it will one day give them a good return.
But even if the property does appreciate in value -- which is no guarantee! --will it appreciate enough to cover the costs to hold it? Don't forget that experts do not invest for appreciation, and you shouldn't, either.
The biggest factor driving your investment decisions should be the annual income the property generates before it's time to sell it. If you're flipping houses, this information is not for you. This is for anyone wishing to buy a residential rental property investment that can be sold later, usually to help during retirement.
How to Calculate Income and the Cap Rate
These four steps will help you make smart investment decisions like the professionals.
1. Figure the annual rent you can expect
If the property is already rented, you probably already know the annual rent figure. If not, check Craigslist, real estate offices and other resources to find a fair market rate.
2. Estimate annual expenses
These expenses include:
- Projected vacancy costs (5-10% of annual rent)
- Real estate taxes
- Utilities that you will pay, such as water
- Property and liability insurance
- Repair and maintenance costs
3. Annual net income
Now calculate your annual net income, which is the annual rent amount minus annual expenses.
4. Calculate the cap rate
This is the expected annual return of your investment, which you find by dividing the net income by the cost of the investment property.
As an example, let's say you rent out a two-bedroom home for $2,000 per month, or $24,000 per year. Your annual net income, after expenses, is $17,000. The asking price for the property was $325,000.
To calculate the cap rate: $17,000/$325,000 = 5.2%.
Understanding Your Cap Rate
As you can see, the higher the cap rate, the higher your annual return. If you want to make a minimum of 5% off your investment every year, this should be the driving factor in making your purchase decision. You can also divide the calculated net income by your target cap rate, which helps you determine the price you should be willing to pay for a property.
It's important to understand that the cap rate you buy at varies by location and the return necessary to make the investment worth it. A professional buying a commercial property may buy at a 4% cap rate in areas of high demand, or 10% in low-demand areas. Anywhere from 4% to 10% annually is a good range to earn on your money.
Regardless of your target return rate, make sure you have a good amount of money left after the mortgage is covered. If a tenant stops paying for a few months, and you have a cap rate of 2% or less, your investment will start to lose money. Make sure you check the projected return for worst-case scenarios to make sure you can cover the property when it isn't occupied!
Think of appreciation as an added bonus, when you can get it, but not a strategy to get you money today.