This series of articles aims to explain the different aspects of investment analysis in real estate investing, which include investment property analysis, comparative market analysis, and the property valuation methods, while also explaining the different aspects of each and the tools used to conduct investment analysis with ease and at high efficiency.
- What Are the Different Property Valuation Methods?
- How to Calculate Cap Rate?
- How to Calculate Cash on Cash Return?
- What Is an Investment Property Calculator?
Cap Rate in Real Estate Investing
In the previous articles, we have discussed the general aspects related to investment analysis and went on to write more comprehensive and in-depth articles about the different aspects of investment analysis, such as the market analysis and the investment property analysis which deals with the individual property and the aspects related to it.
While investment property analysis deals with the general characteristics of a property, such as its location, type, and size, as well as the more specific aspects related to the property’s returns and profitability, we highly emphasized the importance of conducting property valuation during investment property analysis, and we went into more details on the different methods used in a property valuation process in order to determine the property’s value based on its price, type, size, and estimated return on investment.
One of the major metrics used in property valuation and in investment analysis, in general, is the cap rate value of an investment property.
The purpose of this article is to focus on this specific metric and its use in real estate investment analysis, and how to conduct investment property analysis and property valuation based on cap rate to help you find investment properties that will generate the returns that you are hoping for on your investment.
This article will answer the following questions:
- What Is Cap Rate?
- How Is Cap Rate Calculated?
- What Is an Investment Property Calculator?
- What Is Good Cap Rate for an Investment Property?
What Is Cap Rate?
The cap rate is a metric used in investment analysis to determine the rate of return on an investment property based on its current market value and the net operating income that it is generating or that it is estimated to generate.
In property valuation, calculating the return on investment is a key component of your investment analysis, as it will allow you to know what profit to expect to make on your investment.
Since the return on investment metric is a broad term that is used in investment analysis, there are multiple variations of it that are designed to give more specific information about an investment and its profitability.
Basically, the cap rate is a metric that is used to estimate the investor’s potential return on all cash investments.
How Is Cap Rate Calculated?
The formula for calculating the cap rate value for an investment property is simple:
CapRate = Net Operating Income (NOI)/Property’s Current Market Value
To break it down further, let’s take a look at what the NOI and what the property’s current market value means.
The NOI of an investment property is simply the annual net return on the investment property after discounting all of the operating costs.
The property’s current market value, on the other hand, is just as the name implies; it is the price of the property at the current point in time.
Now, let’s get to the math of this.
In order to calculate the NOI, you first need to calculate the annual gross income of your investment property.
So, let’s suppose that your investment property is a rental property that you’re renting out to tenants for $1,200 per month. The annual gross income for this rental property would be $14,400 ($1,200 x 12).
The net operating income of an investment property is the annual gross income minus all the expenses related to running the property.
So, if the annual gross income of the investment property is $14,400, and its total annual expenses amount to $7,000, then your net operating income would be $7,400.
Now that you have the value of the NOI, it’s time to identify the current market value of the investment property.
If the investment property has just been sold, then its current market value would typically be the price at which it was sold, unless the property has been renovated, in which case you will need to appraise the property to determine its new market value. If the property is offered on the market for sale, then its current asking price is its current market value.
Now, to calculate the cap rate based on these values, let’s suppose that the current market value of the property in our example is $100,000.
To put these numbers in action, let’s go back to the cap rate formula and see the final result:
Cap Rate = NOI/Current Market Value
Cap Rate = (Annual Gross Income – Expenses)/Current Market Value
Cap Rate = ($14,400 – $7,000)/$100,000
Cap Rate = $7,400/$100,000
Cap Rate = 0.074
Since the cap rate is typically expressed as a percentage value, you can multiply the final result by 100, so the cap rate for the example would be 7.4%.
What Is an Investment Property Calculator?
There are multiple types of investment property calculators that are used in property valuation. Each calculator is designed to extract specific data to calculate a specific type of return on investment.
An investment property calculator is a calculator that can be used to calculate the cap rate of an investment property. It is one of the most popular tools used in real estate investing, as it greatly reduces the amount of time needed to conduct the necessary calculations.
The investment property calculator is used to conduct predictive analysis and to help real estate investors make more money by obtaining data to help them predict the amount of profit that they would be making on an investment property.
Using the investment property calculator, you can quickly compare real estate properties, and you can also use it to determine how much rent you should be charging for a rental property.
The Mashvisor calculator is unique in that it allows the user to calculate not only cap rate, but also a number of other different values that are all interconnected. Using the Mashvisor calculator, you can customize and modify a number of different values, such as the cash you paid down on an investment, the amount of mortgage, and the different expenses in order to acquire results for the cap rate, the cash on cash return, or the rental income that you will be making.
What Is Good Cap Rate for an Investment Property?
Finally, after you’ve learned how to calculate the cap rate for an investment property in order to conduct investment analysis or property valuation, how do you determine what is good cap rate for an investment property to identify the good investment opportunities from the bad ones?
First, it should be noted that the cap rate varies based on the type of the property. For instance, multifamily properties consistently have lower cap rates because they are considered to provide a lower risk.
This is a very important aspect of cap rate. The higher the cap rate, the higher the return on investment, which also means it the higher rate of risk associated with it.
Apartment buildings, for example, generate their rental income from a number of tenants each month. In this case, if one or two of your tenants fail to pay their rent for a certain month, the change in your cash flow for that month will be relatively small. On the other hand, imagine a large luxurious house that you rent out to a single family. If the tenants of this house don’t pay their rent for a single month, you’re left with no rental income at all, which means a higher risk.
Additionally, the cap rate is different from one market to another. As we at Mashvisor like to keep repeating, in real estate investing, location is everything. Different locations, from cities through neighborhood to different states, all have different cap rate values.
This is partially due to rents, operating costs, and acquisition costs, and how they differ from one place to another, as well as over time. Different markets also exhibit different supply and demand, which can also cause significant differences.
So, while cap rate can be used to compare the risk and the profitability of comparable properties within a single market, you can’t use it to compare properties in two different locations unless you’re certain that these two different locations have identical or very similar stats.
In order to determine the cap rate value that you should be aiming for, it is best to use the area’s average cap rate as your minimum acceptable rate and try to find properties that have a cap rate that is higher than the average depending on the level of risk that you want your investment to have.
To Sum Up
The cap rate is a very useful metric when conducting investment analysis in general, and property valuation in particular, as it gives you a very clear idea of the return on investment that you should expect to make from an investment property.
Despite the cap rate being somewhat simple to calculate, the process of collecting data and calculating the different cap rate values for a number of different properties can be a very daunting and time-consuming task. For that reason, it is usually best to use an investment property calculator in order to achieve the most accurate results in the least amount of time.
Finally, if you want to learn more about the average cap rate for a specific city or neighborhood in order to decide on the best cap rate for your investment property, head over to Mashvisor and start searching the area of your choice, and you will be provided with all tools and data that you need, from the area’s averages, through the specific property’s cap rate, to a powerful calculator that can calculate cap rate, cash on cash return, and other values.