As a real estate investor, it’s important to know at all times if your investments are profitable. If you don’t, then you can quickly dig yourself a hole that could be extremely difficult or impossible to get out of.
While this can seem daunting, particularly if you’re new to real estate investing, it doesn’t have to be, and in this article we’ll be talking about how you can figure out the return on investment for your properties using the cap rate method.
The cap rate, or capitalization rate, is a term used by real estate investors to indicate the rate of return that is expected to be generated on a real estate investment. This is based on the income which the property is estimated to generate for the investor.
Knowing your cap rate is vital because it helps you to see whether a property will generate a worthwhile return for the time and funds which you have invested in it. This number is displayed as a percentage, and it’s generally a reliable way of estimating your return on investment.
There are a few different ways to calculate the cap rate for your investment property, but we’re going to talk about one of the most common and easiest formulas which you can use.
The “net operating income” is the expected annual income which will be generated by the property. So, for example, if you planned to purchase a property which would rent for $2,000 per month, then your net operating income would be $24,000, but you also need to take expenses into account.
This means you need to deduct anything required for the upkeep of the property such as insurance, taxes, property management fees, and estimated maintenance costs from this number.
While it can be tough to budget for everything, some people set aside 1% of the total property value for maintenance costs every year. Once you have your net operating income figured out, divide it by the current market value of the property to get your cap rate.
As an example of cap rate, let’s assume that you’re looking to buy a million dollar property, which you estimate will return you $70,000 per year.
So, how do you know if your cap rate is good or not? Unfortunately, the answer to this question is debatable, but most people look to have a cap rate that is somewhere between 8 and 12%.
While you might be tempted to call it a day if your investment falls within the “acceptable” cap rate range, there is a bit more to it than that, unfortunately. There are actually a number of factors which might cause you to pump the breaks on an investment, even if the cap rate is arguably decent.
Not all properties are created equal, and there are some other factors that could impact your cap rate assessment. Here’s a short list of some things to look out for if your calculated cap rate is too good to be true.
What kind of property are you investing in? A commercial property would likely warrant a much larger cap rate, because if the economy tanks you could be sitting on a sizable amount of debt with no one to rent your space.
A residential property would likely be a safer bet because people always need housing. A slightly lower cap rate may be acceptable here if the property shows potential.
Location is everything in real estate. So, before you decide a property is a great deal because of its cap rate you should evaluate where it is located. How difficult will it be to rent this property consistently? Are there enough jobs here to support a healthy rental economy?
What kind of rental is this? If you’re purchasing the property as a high dollar vacation rental, then your average rent will be much higher, but you might also pay more in maintenance costs than you would with a long term rental.
You should also make sure to factor in that your rental could end up sitting empty in the offseason, even if it’s in an otherwise attractive location, lowering your annual income.
Have you checked how many other properties are for rent in the area you plan to invest in? While your chosen rental may look like a great deal, it might not actually be if there are too many other properties to compete with.
Other landlords will continually drop their prices to stay competitive, and you could end up with either an empty property or one that is rented far beneath what you thought you were going to actually get for it. Buyer beware.
Cap rates are important for making sure that you aren’t taking on debt for an asset that won’t be able to pay for itself. It’s easy to get fooled into thinking that you’ve picked up a great deal, but there could be a very good reason that the property has been on the market for a year with no takers.
Using the cap rate method also allows you to easily compare properties to each other. If you’ve been eyeing more than one rental for your portfolio, then the cap rate could be the deciding factor that helps you see which properties earn more money for you.
If you’re purchasing properties with financing, then the cap rate is also valuable for determining how long it will take you to own the property free and clear.
In closing, the cap rate formula is a great tool for real estate investors that’s both easy to use and useful for seeing the bigger picture. You owe it to yourself to take advantage of every tool you have to make sure that your investments are successful, don’t ignore cap rates or you may quickly come to regret your new “asset”.
Investment scores, estimated rental values, estimated mortgage costs, and any other financial or other data contained herein cannot be guaranteed as accurate and should not be solely relied upon in making any investment decisions. Users of this information should conduct their own due diligence before making any investment decisions and Zumbly shall not be responsible for any inaccurate information or estimates listed herein.