Smart 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:
- 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.
- 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.
- Calculate your annual net operating income (NOI).
This is the annual rent minus the annual expenses.
- 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!