Mashvisor real estate investment services open the doors for many real estate investors to find their next real estate investing opportunity in different cities and neighborhoods. While getting access to our unique investment opportunities is great news for every real estate investor, the important question is: How can you compare the different investment opportunities and find the best real estate investment that promises a high return on your investment? The answer is simply by calculating the cap rate for rental property. So, how to determine cap rate and why is it important for property investors? Tune in!
Cap Rate for Rental Property: Definition
The cap rate, short for capitalization rate, is your real estate investment’s rate of return based on how much income the rental property is going to generate for you. Determining the cap rate for rental property is very important because, after all, you are not going to invest with the intention of losing money.
The simplicity of this great tool makes it easy to estimate and compare the return on investment (profitability) of different investment properties. Whether you are investing in single family homes or multi family condos, calculating cap rate for rental property measures the capability of an investment property to recover the initial investment and generate profits.
How to Determine Cap Rate: Cap Rate Formula
Before you buy an investment property, it is important to perform a real estate investment analysis. One of the main components of real estate investment analysis is determining cap rate for rental property which can be calculated using the cap rate formula:
Cap Rate = Net Operating Income / Current Market Value
The net operating income (NOI) of a rental property is the total income after deducting property taxes, maintenance costs, and property insurance. It is important to note that NOI does not take into account the financing method and therefore, mortgage payments are not deducted from the gross income when calculating NOI.
If you are calculating cap rate for rental property of a known market value, then you save yourself the trouble of estimating it. If the current market value is unknown, it can be estimated using the sales prices of comparable properties. Comparable properties or real estate comps are investment properties that share similar physical features (square footage, year of construction, number of bedrooms and bathrooms, etc…) and are located in the same area as that of the property in question.
For more information on how to find real estate comps to estimate the market value of a rental property, click here.
How to Determine Cap Rate: Cap Rate Calculation Step by Step
The first step to calculate cap rate for rental property is to gather all the numbers you need to determine the net operating income.
1- Calculate the yearly gross income of your investment property. The gross income of a rental property is the monthly rent you intend to charge your tenants. Let’s say you rent out your rental property for $1,000 per month, the yearly gross income would be 12 x $1,000 = $12,000.
2- Subtract the operating expenses of the rental property from the yearly gross income. As you have probably learned so far, owning a rental property comes with operating costs. Usually, these are in the form of insurance, taxes, property management, maintenance, and vacancy costs.
For example, let’s say that you expect to pay $200 in property management, $300 in maintenance, $600 in taxes and $600 for property taxes. Your net operating income would be the gross income minus all these costs. ($12000 – $200 – $300 – $600 – $600 = $10,300).
As mentioned earlier, to estimate the market value of a real estate property, you need to examine recent selling prices of similar real estate comps. But let’s say you know the property’s value, then you can easily move on and calculate the cap rate. For example, the market value of the property above is $150,000; its cap rate is simply the net operating income divided by its value ($10,300/$150,000 = 0.069 or 6.9%).
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Determining Cap Rate for Rental Property: Why Is It Important?
Cap rates can be useful for real estate investors in two ways. First, based on market cap rates of recently sold comparable properties, you can estimate the value of a given real estate property simply by dividing NOI by the cap rate. Second, when buying a real estate investment, knowing the cap rates of different properties makes it easier to compare properties to see which would be a better purchase.
Moreover, when deciding to buy an investment property, knowing the cap rate from comparable properties can help you decide if a deal is worth it. For example, in a certain area where cap rates for single family homes are 10%, a property is listed for $150,000. If the net operating income of this property is $11,000, is it worth the asking price? The answer is no because dividing NOI by the cap rate gives you a lower value ($11,000/0.1 = $110,000). Therefore the asking price is too high for that market.
Related: Best Places to Invest in Real Estate Based on Cap Rate
What Is a Good Cap Rate for Rental Property?
What makes a ‘good cap rate’ depends on your investment goals and the type of property you are planning to invest in. However, most real estate investors would consider a cap rate of around 10% to be good. As a rule of thumb, the higher the cap rate, the higher the risk associated with the real estate investment.
Related: What’s a Good Cap Rate for Investment Properties?
Cap Rate for Rental Property: Conclusion
When asking how to determine cap rate for rental property, one should first understand the meaning of cap rate in real estate investment and how it can be used to make wise investment decisions. That being said, knowing how to determine cap rate for investment properties is one of the basics of real estate investment analysis.
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