The prospect of earning a profit by investing in rental properties is exciting. However, the reality of real estate investing is a lot more complex than one may think. It’s critical for property investors to understand how to properly assess investment properties with the right calculations and tools. Without crunching the numbers of costs and potential gains, you’re setting yourself up for loss. This is why it’s important to know the ins and outs of the cap rate formula to accurately determine the profitability of rental properties.
If you’re new to the real estate investing industry, keep reading as we dig a little deeper into the cap rate and explain how it’ll help you find the best investment properties.
What Is the Cap Rate?
The cap rate is a metric used in real estate to determine the profitability of an investment. Essentially, the cap rate is the net operating income (NOI) of a rental property in relation to the property’s asset value. Property investors and other players in the real estate business use the cap rate formula to estimate the potential return on an investment (ROI).
If you’re wondering how to calculate the cap rate of an investment property, you simply divide the NOI by the value of the property. This will give you a percentage that indicates the annual rate of return on the rental property. While the structure of the cap rate formula is straightforward, there are plenty of factors that affect the cap rate of a real estate property – we’ll explain these as we go through an example for calculating the cap rate later on.
If you’re not into long math problems, there are real estate investment tools to help you evaluate rental properties. Mashvisor’s Investment Property Calculator will estimate a property’s cap rate, cash on cash return, rental income and cash flow for you so you can find out if you’re getting a profitable deal. This tool is also sometimes referred to as the Cap Rate Calculator. To learn more about our product, click here.
Why Cap Rate Is Important to Real Estate Investors
The cap rate formula is an important metric for real estate investors because it offers a quick, yet accurate estimation of a rental property’s profitability. In addition, it also gives property investors the ability to understand their ROI and to compare potential investments before investing their money. Here’s how the cap rate is critical to finding the best properties for real estate investing:
1. Accurate Understanding of Operating Costs
When it comes to running and operating a rental property investment, a beginner real estate investor can easily lose control over his/her costs. However, knowing how to calculate cap rate gives you the chance to understand all of the operating costs in detail. Not only does this allow you to make the best real estate investment decisions, but it also helps bring some expenses (that you may have not been aware of before) to your attention.
Related: The 6 Hidden Costs of Owning Rental Property
In turn, this helps you identify what costs to cut off in order to increase your NOI and improve your cash flow and cap rate. For example, you may realize that the investment property has excessive energy costs because of an inefficient HVAC system. By examining the NOI using the cap rate formula early on, property investors are able to identify what changes need to be made to increase the profitability of their rental properties!
2. Choosing Between Investment Options
As a real estate investor, you might find yourself in a situation where you have several investment options available to you. For example, say you’ve found three similar single-family home rentals in the same neighborhood or housing market. Which one should you go for? At first, it may be overwhelming to pick the right type of real estate investment.
However, understanding the cap rates of all of these potential investments should help you to make the best decision. Using the Cap Rate Calculator gives you the ability to see which real estate property will yield the highest return on investment. You might be surprised at just how much difference there is between two similarly priced rental properties for sale when it comes to the annual rate of return.
How to Calculate Cap Rate
As mentioned, the basic cap rate formula is to simply divide the NOI by the property’s value. However, the actual calculation can be a bit more complicated. For property investors to accurately estimate a rental property’s cap rate, it’s important to use comprehensive and detailed numbers. This should make it easier to thoroughly understand both the property’s value and its operating costs. Here are the steps to calculate the cap rate for any real estate investment property:
- Calculating the NOI: To do so, a real estate investor has to add up all expenses except the mortgage and interest payments. Some operating expenses that should be included in the NOI calculation include property management, taxes, utilities, HOA’s fees, and insurance.
- Add all of these expenses up and subtract the sum from your gross rental income (yearly rent). This will give you your net operating income.
- Lastly, divide the NOI by the investment property’s current market value.
Cap Rate for Rental Property – Example
Let’s walk through an example to give you an idea of how to calculate cap rate for your rental property or a property you’re considering for real estate investing. Say that the market value of a rental property for sale is $100,000. The rental income that you can earn from renting it out is $1000 a month (or $12,000 a year). Furthermore, say that your ongoing monthly operating expenses are:
- Property taxes: $100
- Property management: $100
- Utilities: $60
- HOA fees: $50
- Insurance: $40
So, in this case, your total operating expenses are $350. For more accurate cap rate calculations, let’s account for a 10% vacancy rate. This will take the monthly rental income from $1,000 to $900. Subtracting the total expenses from the monthly rent gives you $550 monthly NOI. Multiply this by 12, and you’ll have $6,600 annual NOI. Going back to the cap rate formula, simply divide the yearly NOI ($6,600) by the property’s value ($100,000), and you’ll get a 6.6% cap rate.
When to Use the Cap Rate Formula
While cap rates are good indicators of the return that property investors can expect from real estate investments, it’s important to remember that cap rates are highly location dependent. This means that what might be a good cap rate in California is not the same as a good cap rate in Michigan. Therefore, you should only use the cap rate formula to determine the profitability of investments in the same location.
Moreover, the cap rate formula can only be used to decide between similar properties of the same type (real estate comparables) in that location. For example, you might find 3 – 5 single-family homes for sale that are similar in condition, age, and amenities but have different listing prices. In this case, calculating the cap rate will help you compare these investment properties to determine which one has the best ROI.
Note: Mashvisor’s Investment Property Calculator provides investors with comps so you don’t have to go through the hassle of finding them yourself! To analyze and compare investment properties in your city and neighborhood of choice, start out your 14-day free trial with Mashvisor now.
Another good use of the cap rate formula is to identify patterns and trends in the housing market. To succeed in the real estate investing business, you need to become an expert in your market. So, start by gathering current and historical cap rate data to see the changes in real estate profitability over time. This should allow you to predict where the housing market is going. For example, if there has been a steady upward trend in cap rates, you can expect that they’ll continue to climb and give you a good return on investment over the long-term.
Related: What Real Estate Market Trends to Look for Before Making an Investment
When NOT to Use the Cap Rate Formula
There are some occasions when it’s not very useful to use the cap rate for analyzing an investment property. First off, remember that cap rate is only one real estate metric among many. Therefore, property investors should never use it as the sole determining factor to choose where to invest in real estate.
Furthermore, it’s important to mention that the cap rate is effective for estimating the ROI on a property you rent out and not for other kinds of real estate investments. For example, it’s not effective to use the cap rate formula for calculating the ROI of properties you plan on flipping and selling soon after purchase. For this type of investment, it’s best to use other real estate metrics to determine profitability.
What’s a Good Cap Rate for Profitable Investments?
It’s difficult to pinpoint exactly what a good cap rate is. The answer really depends on the housing market you’re in and your goals as a real estate investor. We already mentioned that a good cap rate is different from one state to another, but it’s also different in cities and even in neighborhoods of the same market.
Interested in learning the cap rates of major cities across the US housing market? Read 2019 Cap Rates by City: What Real Estate Investors Should Expect
In addition, the type of rental property also affects cap rates. For example, multi-family homes typically have lower cap rates because they’re less risky investments. Investment property interest rates also play a role in what is a good cap rate for rental properties. For these reasons, one real estate investor may be willing to accept a cap rate of 7% or lower while another would not.
Final Words for Real Estate Investors
When it comes to the cap rate formula (and other real estate metrics used to determine the profitability of investment properties) you never use it as the only determining factor in your decision making. There is no single metric that gives property investors an ultimate property analysis. Therefore, you should make use of the different tools available that help you calculate all of the key metrics to find profitable investment properties – like Mashvisor’s Investment Property Calculator!
Want to give our tool a try? Click here to start your 14-day free trial with Mashvisor and subscribe to our services with a 20% discount after.