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Understanding the Cap Rate When Buying Investment Real Estate

Image of a desk with financial papersSmart real estate investors use a variety of financial tools to guide their buying decision—one of which is the capitalization rate, or cap rate.

What is a cap rate? In simple terms, the cap rate shows the annual return expected on an investment. In mathematical terms, it is the ratio of Net Operating Income (NOI) to property asset value. For example, if a property recently sold for $1,000,000 and had an NOI of $100,000, then the cap rate would be $100,000 divided by $1,000,000, or 10%.

For any long-term real estate investor, the primary financial driver guiding your buying decisions should be the annual income the property will generate. If you’re a property flipper, the cap rate may not concern you. However, if you’re buying properties to rent them out long-term, then the capitalization rate is important to you.

How to Calculate a Property’s Cap Rate

Determining a property’s capitalization rate is actually quite easy. Here are the four steps:

  1. Determine the annual rent you can expect from the property.

If the property is already rented, this is easy to calculate. Otherwise, do some research.

  1. Estimate the annual expenses of owning the property.

This will include taxes, insurance, utilities you will pay on an ongoing basis, projected vacancy costs, and repair costs. Note that the cap rate does NOT include any mortgage expenses.

  1. Image of woman looking at a table with financial dataCalculate your annual net operating income (NOI).

This is the annual rent minus the annual expenses.

  1. Calculate the property’s cap rate.

Divide the NOI by the cost of the property. For example, suppose you’re looking to buy a two-bedroom condo. It currently rents for $3,000 per month, or $36,000 per year. You’ve calculated the annual expenses at $9,000. That gives you an annual net income of $27,000 ($36,000 – $9,000 = $27,000). The property’s asking price is $325,000. To calculate the capitalization rate, divide $27,000 by $325,000. Your cap rate is 8.3%. If you can negotiate for a lower price, your rate would increase.

The higher the capitalization rate, the better the annual return on your investment. Many investors aim for a rate between 4% and 10%. Whatever rate of return you are aiming for, make sure the projected income leaves you with a healthy amount of cash after the monthly mortgage payment has been paid.

By calculating the cap rate for each investment property, you can be sure you’re making sound financial decisions.

If you’re searching for the perfect property to buy for rental purposes, we can help! Contact us today!

 

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Welcome! We are glad you’re here. We developed this website to give you the most up-to-date Napa Valley real estate listings and the most reliable information for home buyers and sellers.

Not sure where to start? Check out our blog, vlog, and articles for information on buying and selling a home, design and staging tips, and real estate investor information.

Ready to buy? Be sure to browse our current listings.We are eager to show you your next Napa Valley home.

Relocating to the area? Read up on all the great communities that make up Napa Valley.

Is it time to sell your home? Why not have the #1 real estate team represent you?

We’re sure you have questions. And we are here to help. Contact us for information on anything real estate related.

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Leading the Pujals team are Jerry and Susan Pujals, who is ranked as the #1 Sales Team for California, Coldwell Banker Brokers of the Valley. Jerry, a Senior Broker, and Real Estate Advisor began his career in real estate with Coldwell Banker Brokers of the Valley in 1997. Susan, a seasoned Real Estate Sales Consultant joined the organization in 2008, which established the formation of The Pujals Team.

Having received national recognition for their performance and many local awards, Jerry and Susan are proud to be affiliated with Coldwell Banker Brokers of the Valley, Napa County’s real estate market leader for more than 20 years.[Read more]

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