Whether you're just starting as a real estate investor or you've been in the business for years, you should know the importance of a reasonable cap rate. But a cap rate is a number that represents performance, so a reasonable cap rate is not uniform for all investors.
You cannot use a single calculation to determine whether an investment suits you. However, by becoming knowledgeable about the various valuation tools and when to apply them, you'll prepare to identify the approaches that will be effective for any opportunity you come across.
When investing in rental property, you want to keep one thing in mind: the cap rate. What is a good cap rate for rental property, why is it important, and how can you find the best cap rate for your property? Here's everything you need to know.
What Is A Cap Rate?
Comparing different real estate investments or markets involves using a cap or capitalization rate. Most frequently, it is the proportion of a property's initial purchase price to net operating income (NOI).
A reliable method for determining the strength of an investment is to look at the cap rate. A cap rate is a calculation that tells a potential investor how much money they stand to gain or lose if they decide to purchase the property.
After deducting all running costs, the property's annual income is the net operating income. Taxes and administration costs for the property are included, but not mortgage payments.
NOI is the net operating income after deducting vacancy, taxes, insurance, maintenance, and other operating costs.
The cap rate is the rate of profit you may anticipate on your investment. Better cap rates are those that are higher.
The formula below shows how to calculate cap rates.
NOI/Current market value × 100% = Cap Rate
A cap rate should be accurately estimated and supported by thorough research and attention to detail. Cap rates should be used alongside other measures rather than as a stand-alone indicator. A cap rate and more data can significantly reduce the risk that an investor may get exposed to during an investment.
Cap rates are vulnerable to inherent mistakes and should not be considered a substitute for accurate stock market predictions. The cap rate will only provide investors an estimate of how much they stand to gain rather than an actual figure.
How to Calculate Cap Rate
There are several ways to determine the cap rate on a rental property. We'll focus on the most popular method we mentioned above.
NOI (net operating income) ÷ Current market value × 100
It's crucial to remember that the property price increases when the cap rate decreases. Property prices fall as cap rates rise.
Since you need your net operating income to calculate your cap rate, you must know how to determine your NOI. Take the following steps to find your NOI
Determine the gross rental income
Calculate how much rent you'll get per year if a tenant has already rented the property. Double the monthly rent by 12. If you think the rent is too low, or if there is no tenant in the property yet, find out and compare the rates of other similar properties in your area.
Look through the rental listings on top property websites and any other popular listing service in your area to do thorough research.
Calculate running costs to determine the annual property ownership budget
To determine the annual budget, you will need to consider the following factors:
- Your anticipated budget for regular maintenance, repairs, and remodels
- Real estate taxes utilities that you will pay, such as water, Internet, or gas
- Property and liability insurance.
Do the maths
To calculate your net operating income, subtract your operational costs from your total rental income. It is best to use the market price or the price you plan to offer.
Let's say you want to invest $544,002 in a three-bedroom rental property. Currently, the rent is $3,520 monthly.
12 (months) times $3,520 (monthly rent) equals $42,240 in gross rental revenue.
Let's say your annual operating cost is $9,484, $3,500 in maintenance and other expenses, and $5,984 in property taxes.
Your anticipated net operating income is $32,756 ($42,240 – $9,484).
To calculate the cap rate, divide your net operating income ($32,756) by the property's list price ($544,002 in this case), and multiply the result by 100.
($32,756 ÷ $544,002) × 100 = 6.0
6.0% will be the cap rate return on this three-bedroom property if your calculations are accurate.
Take occupancy rate into account
The formula above works well for assessing potential investments and quickly summarizing a purchase. However, it presupposes a 100% occupancy rate. Adjusting your net operating income for a less-than-ideal occupancy rate is how to calculate the cap rate on rental property.
To factor in the occupancy rate, change the net operating income calculation formula to the following:
(Gross rental income × occupancy rate) – (Operating Expenses) = net operating income
Most real estate investors factor 5% and 10% expected loss into their estimates. Therefore, in the example given above, if you were to assume a 90% occupancy, your net operating income would be:
($42,240 x 0.90) – $9,484 = $28,532.
A 10% decline in occupancy leads to a $4,224 decrease in net income.
Cap rate = ($28,532 ÷ $544,002) × 100 = 5.2%
The three-bedroom property has a cap rate return of about 5.2% when considering occupancy, making it less appealing.
Perfect occupancy is more challenging to obtain than most investors realize. Examining every aspect of occupancy rate is crucial to investing in rental property. You can get a cap rate that is more realistic by considering the occupancy rate. These modifications can help you avoid smaller margins and give you a clearer sense of the possibility of return.
The Dividend Discount Model
The dividend discount model, popularly known as the Gordon Growth Model(GGM), determines how much a company's stock price is worth. It is a cap rate calculation model that every investor should be familiar with
(Required Rate of Return - Expected Growth Rate) = Expected Cash Flow / Asset Value
Cash Flow = gross monthly rent income – total monthly expenditure (including utilities, maintenance, and debt servicing).
Asset value is the property's current market price.
The Internal Rate of Return
When determining the economics of a buy-and-hold investment, the internal rate of return (IRR) is crucial. The calculated amount will show how much profit investors can anticipate from renting and finally selling an investment property.
(Cash Flow + Expected Property Valuation) ÷ Estimated Hold Period = Internal Rate of Return
It's advisable to use different approaches in addition to IRR. This method helps provide an estimate of a property's value. However, it cannot accurately predict a property's valuation because it relies on estimates.
What is a Decent Rental Property Cap Rate?
How do you determine a reasonable cap rate for a rental property? That's probably the first question that comes to mind after discovering how to calculate cap rates.
Generally, the best cap rate for rental property is between 4% and 10%, although some argue it is better between 8% and 12%. It's crucial to distinguish between reasonable and safe cap rates.
This is because the method measures net operating income in the original purchase price. Therefore, investors looking for offers with a cheap purchase price might prefer a high cap rate.
However, what constitutes excellent ROI for rental properties will rely on several variables, including:
- Capacity for risk
- The property's current rental Value
- Future rent forecast (pro forma rental)
- Future increase in property value
Factors That Affect Cap Rate
When it comes to cap rate, there are certain things every rental property investor should know.
What is a good cap rate for a rental property? How can you calculate it, and what factors affect a property's cap rate? Below, we will answer the third question.
Areas with relatively expensive rental properties and higher demands like Los Angeles or New York typically have a lower cap rate on average. In contrast, typical cap rates of 10% or higher may appear in areas with reduced demand, such as developing neighborhoods or rural areas.
The location of your property will help you find its value or, at least, give you a rough idea of its market value. With that, you can estimate your property's cap rate based on the average cap rate of rental properties in the same area.
Capacity for Risk
A good investment, in most cases, depends on your capacity for risk. Rental property investments are like any other real estate investments regarding ROI calculations.
For example, an investment with a 4% cap rate and another with 7% don't come with the same risks. A property with a 4% cap rate will be a better option if you want a stable and passive ROI. It will most likely appreciate steadily over a long period.
If you have a high-risk tolerance, you may consider the property with a 10% cap rate more attractive. High risk comes with a high reward. This property has more potential for appreciation. However, it is less stable than the one with a 5% cap rate. You should weigh your options carefully by considering as many variables as possible.
A higher cap rate means higher risk, whereas a lower cap rate implies reduced risk. You always use cap rate in addition to other calculations and should never take on more risk than you are comfortable with.
The Property's Current Rental Value
When you first purchase the property, it is ideal to have the rent as high as possible because this will raise NOI and provide you with a higher cap rate.
However, it helps if you do not assume the property's rental income is its current market value. Instead, once you have increased the property's value, you should figure out the cap rate—the cap rate rises in tandem with rising rents.
Future Rent Forecast
Throughout the lifespan of your property, you will need to make changes and improvements. You may even need to make upgrades in the beginning unless you purchase an A-list home.
The objective is to charge higher rents and reduce your vacancy rate. That's where a rent pro forma comes in. You will need it to forecast future rent and vacancy rates.
When a rental property is fully stabilized and working at maximum efficiency, a rent pro forma provides a comprehensive breakdown of the revenue and costs.
Peak efficiency refers to a property having market rents, income, vacancy rates, and the best cap rate for a rental property compared to similar properties in the market.
Future Increase in Property Value
In some cases, value appreciation is just as good as cash flow. However, making cash flow projections is more straightforward than predicting value appreciation. But with the help of modern rental property management technology, it is now possible to predict value appreciation precisely.
As was said above, the specific market you're considering influences the cap rate. In other words, you can use $500,000 to buy properties with different NOIs.
A $500,000 property will generate $20,000 NOI with a 4% cap, and $50,000 with a 10% cap.
These homes cost the same, but their returns vary depending on the market and region.
Suppose you bought a property with a 4% cap rate in Henderson Paradise, Nevada, ten years ago. It would have performed better than a property with a 10% cap rate in Columbia, Maryland.
The nearby buildings have an impact on the cap rate as well. If two buildings in the same area, one recently upgraded and the other not, are compared, the newly updated building may trade at a 4% cap while the one needing renovations may trade at a 10% cap.
Why is Cap Rate Important to Rental Property Investors?
The cap rate can be crucial in determining an investment's quality. It can aid you in selecting the best investments for your portfolio when used as a significant metric from various viewpoints.
A Rental property's cap rate can also help you evaluate properties, such as;
- Rental properties for one family
- Multi-family properties
- Commercial real estate
- Housing complexes
Establish revenue and profits.
The initial yield of a rental property may show by looking at the cap rate. The most incredible way to assess an investment's ROI is by looking at the cap rate. It compares the income you receive with the amount you invested in the property.
Decide the ROI period.
The cap rate determines the years it will take to make back the initial investment. For instance, it will take four years for a property with a cap rate of 4% to make back the investment.
Investment properties get compared.
The cap rate is helpful if you have three properties of the same price, of the same type, or next to each other. The choice of which property to purchase will be clear-cut based on whether the property has the best cap rate and is producing the most revenue.
There are no mortgage costs included in the cap rate. Excluding finance from the analysis provides a more accurate result. The cap rate is about the rental property alone.
Note that the cap rate may not be as valuable in other situations as it is for rental properties. Since calculating the cap rate depends on annual net operating income, it is not helpful when appraising land, flipping homes, or investing in short-term rentals.
Better annual returns on your investment get achieved with higher cap rates. But it is best to determine how much risk you are willing to take before investing. Ensure the expected income leaves you with a healthy amount of money left over after making the mortgage payment.
To be sure you can afford to carry the property when it's vacant, consider worst-case rent loss situations when evaluating your future return.
The Next Step
What is a reasonable cap rate for a rental property? That's the question that brought you here. Now it's no longer a question. You've learned about cap rates, calculating them, knowing the best rate for your rental property, and why they are essential.
Nevertheless, you will still need help purchasing and running a rental property. At The Short Term Shop, you will receive the guidance you need to make profitable investments in rental properties and other real estate. What’s keeping you from contacting us today?