Calculating the return on investment is the best way to determine the potential profit for residential real estate. There are many methods to calculate return on investment (ROI). One of the most common is through cap rates. So, what is cap rate exactly? How do you calculate cap rate? Why is it used for a rental property analysis? We’ll answer these questions and more in this blog. Here is the complete guide to understanding cap rates for rental property.
What Is Capitalization Rate?
Let’s tackle the first question: What is cap rate for rental property? Cap rate, short for capitalization rate, is one of the most useful measures of ROI. Its primary purpose is to estimate the rate of return on a rental property. In other words, cap rates show how much of an investment property’s value is generated as profit. Cap rate is notable for measuring ROI by excluding financing costs. Since it measures ROI, cap rate depends on many factors. Rental income, operating expenses, and property value, for instance, are used for calculating cap rate.
How to Calculate Cap Rate
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The Cap Rate Formula
So, how is cap rate calculated? As previously mentioned, cap rate depends on many variables. As a result, the cap rate calculation is:
The cap rate formula uses two primary variables. Firstly, cap rate requires net operating income (NOI). NOI is the difference between annual rental income and annual operating expenses. Annual rental income is simply the rent collected by a real estate investor in one year. Operating expenses, on the other hand, are the expenses used to run and maintain the rental property. Common operating expenses include repairs, insurance, property taxes, and much more. As previously mentioned, cap rate does not include financing costs. Therefore, mortgage payments and debt service are not used when calculating cap rate. The second variable is fair market value (FMV). FMV is synonymous with property price at a certain time.
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An Example of How to Calculate Cap Rate
Let’s look at a quick example to demonstrate how to use the cap rate formula. A real estate investor earns $45,000 in annual rent from a townhouse. The investment property costs $5,000 to maintain. The townhouse’s FMV is $300,000. What is its cap rate?
Cap Rate = ($45,000 – $5,000) ÷ $300,000 = 0.133 × 100% = 13.3%
Why Is Understanding Cap Rates Important?
You know now how to compute cap rate for rental properties. But, why is it so important? There are three reasons why you should be understanding cap rates in real estate.
1. Cap Rates Help You Determine the Return on Investment
Most importantly, cap rate is used to estimate the return on investment. Without this valuable metric, a real estate investor cannot find out how much profit a rental property can make.
2. You Can Easily Compare Rental Properties for Sale
Cap rates are also beneficial for comparing properties during your investment property search. Since it does not include financing in the equation, cap rate provides an easy way to compare hundreds of rental properties at the same time. Generally speaking, the higher the cap rate, the more profitable a property can be- we will revisit this principle in more detail soon.
3. You Can Estimate the Real Estate Investment Payback Period Quickly
Finally, cap rate is also used to estimate a property’s payback period. In other words, it estimates how long it will take for an investment property to return all of the money that was invested in it. The estimation is quite simple.
Cap Rate Payback Estimate = 100 ÷ Cap Rate
For the previous example, for instance, the townhouse payback estimate would be:
Cap Rate Payback Estimate = 100 ÷ 13.3 = 7.5 years
What Is a Good Cap Rate for Rental Property?
Speaking of the example, does the townhouse have a good cap rate? What is a good cap rate, anyway? Unfortunately, there is no straightforward answer. The reason why is that there are many factors that influence cap rates.
Buying rental property depends on many variables. These variables can also impact cap rate. Location, for example, is a huge influence on the cap rate real estate metric. Urban areas and metros usually have lower cap rates than suburban areas. Property type is another important factor. Cap rates for multi family homes, for example, tend to be greater than those of single family homes. With multiple units to rent out, multi family properties generate more cash flow.
All in all, the range of good cap rate varies based on an investment property’s location. It is more important to be concerned with cap rates by city than by state, for instance.
What Is Better: A High or Low Cap Rate?
This brings us back to an important note. What is better, a high or low cap rate? On the surface, it might seem like a high cap rate is always better. However, this is not always the case. It is important to understand why a high cap rate property might not always be the best option.
1. Annual Rate
When we break down the NOI, we see that cap rate is based on annual returns. Therefore, if a real estate property investment was profitable or not during a year, it will be seen in its cap rate. However, this says nothing about its performance in previous years. In this way, cap rate can falsely reflect an investment property’s profitability. The best way to avoid this is to study the track record of a rental property’s cap rate.
2. Tradeoff
There exists a tradeoff between high cap rate areas and profitability. In locations with high cap rates, rental rates may be stabilized or near stabilization. Low cap rate neighborhoods, on the other hand, are usually ripe for rental rate increases. In the long-term, NOI in these areas grows. The result is a higher cap rate, ultimately. This is if property prices are similar in the two areas.
3. Risk Assessment
Buying rental property brings risk with it. Not only does cap rate compute profitability, but it also measures risk. In a sense, a higher cap rate can bring higher risk. This is because high cap rates may be coming from the fact that you’re looking at inexpensive investment properties for sale. While everybody loves a good bargain, cheaper homes can sometimes come with issues. They may be located in a bad neighborhood or require a lot of renovation to become livable. All of this can increase the risk.
Where Can You Find Cap Rates for Rental Properties?
Using Mashvisor’s interactive cap rate calculator, you can complete a full investment property analysis when buying rental property. As a result, you can find the best cap rates for single family homes, multi family homes, and all types of residential real estate. Now that you have had the cap rate explained to you, you’re ready to start searching for rental properties.
To start finding investment properties with the best cap rates in the US housing market, CLICK HERE to start your 7-day free trial with Mashvisor!