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Understanding Cap Rates For Rental Investing
Capitalization rates, or cap rates for short, are a useful measurement for the potential
return on investment that a rental property could potentially yield a buyer, based on rental income. They are used primarily for multi-unit rental agreement properties (although can be used on single family dwellings), so many real estate investors who have stuck to other types of investment properties may not be familiar with them.Calculating Cap Rates
For all you non-math majors, the math is as simple as you could ask:
Cap Rate = Annual Net Rental Income / Purchase Price
Here's where things get tricky: net rental income is often a nebulous number, that's not so easy to calculate with any precision. First, calculate the gross annual rental agreement income, for example a property with $3,000/month gross rental agreement income would have a gross annual rental income of $36,000.
Second, subtract out the following operating expenses: average vacancy rates, advertising, insurance, maintenance, property taxes, property management costs, supplies. (There are a few costs that are NOT included, most notably mortgage interest/fees, income taxes from money earned, and major property improvements, e.g. a new roof on the building).
Some of those expenses are easily calculated (property taxes), while others must be estimated (such as vacancy rates). For the purposes of our example, we'll assume a vacancy rate of 25%, so we'll subtract $9,000 from the gross annual rental agreement income total of $36,000, and another $6,000 for the other operating expenses included above, for a net operating income of $21,000.
For the purpose of our example, we'll say the purchase price is $215,000, which would make the cap rate... 9.77%!
Calculating Property Values with Cap Rates
Cap rates can also be used to calculate how much you want to spend on a particular investment property. Most multi-unit rental agreement investors have a target cap rate, which can be used to determine what they're willing to pay for a property; for example, if an investor refuses to buy rental properties with a cap rate of less than 10%, they might make an offer of $200,000 on the property described in the example above, instead of buying for the $215,000 asking price.
To get to that figure, take the net operating income of the property ($21,000), and divide it by the target cap rate of 10%, to reach a purchase price of $210,000. Likewise, you could also use the cap rate and purchase price to calculate the minimum net operating income that the rental property would have to be able to produce, to justify the purchase price.
Capitalization rates are simply one additional tool for evaluating income-producing properties, and may or may not be appropriate for a particular rental property you're considering. While they tend to be most useful for larger apartment buildings, capitalization rates and how to calculate and use them are concepts that all real estate investors should be familiar with, if only for professional literacy.
by: Kevin Kiene