If you’re a seasoned veteran real estate investor, you’re probably familiar with cap rates and what they mean for your real estate business. If not – don’t sweat it. The reason we post is to provide you with the information you need to be the most successful real estate investor you can be. Cap rate – or capitalization rate – is a very important measure in determining whether you’re pricing your rental properties appropriately. In this post, we’ll get into what capitalization rates are, how they’re calculated, and how you can use this information to ensure your own success in your investment activities.
What is a Cap Rate?
Simply put, cap rate is a measure of how much money you make on an investment property. It’s calculated by dividing the net operating income by the property value, expressed as a percentage. For example, if your property generates $50,000 in annual net operating income and has a selling price of $1 million, you would have a 5% cap rate, or an average return of 5%.
Here’s another way to think about it: If you borrow money to buy a multi-unit building and then rent out the units at market rates, how long will it take for your rental revenue to pay off your investment property mortgage? The answer depends on two factors: how much rent you collect from each unit (your revenue stream) and what price you paid for the building itself (your expense).
Of course, cap rates are not the end-all of metrics; on its own, knowing a property’s cap rate is largely useless. But with other data points in the mix, cap rate helps to fill out the bigger picture and mitigate the risk that an investor might be exposed to throughout the length of an investment.
How are Cap Rates Calculated?
In order to calculate the return on investment from net operating income, you must first know the total equity invested in the property, or the property’s purchase price. Next, take your gross property income and find your net operating income by subtracting any monthly property expenses. Lastly, divide your net operating income by your purchase price, and you’ll find your cap rate. Here’s an example:
- Purchase price: $300,000
- Property income: $23,000
- Property expenses: $3,000
- Net operating income: $23,000 – $3,000 = $20,000
- Cap rate: $20,000 / $300,000 = 0.0667 (6.67%)
In the above example, a property that was purchased for $300,000 that has a total annual income of $23,000, minus annual expenses of $3,000, would have a net operating income of $20,000. This puts the cap rate at 6.67%, which is a fairly healthy cap rate.
Of course, the above equation assumes a 100% occupancy rate. Whether you’re investing in multifamily or single family properties, you may have times where not all of your units are leased, or where your property sits vacant after one tenant leaves if you can’t immediately find a new one. To account for this, you can assume a 5-10% loss in revenue by multiplying your gross rental income by 0.9 to get a clearer picture of what your cap rate would be if the property is not 100% leased for 100% of a given year.
What is a Good Cap Rate for Rental Properties?
Cap rates can vary based on a number of factors including property type and location, so there is no end-all be-all answer to this question. However, general wisdom states that a typically “good” cap rate is somewhere in the range of 4-12%. If your cap rate is below 4%, you may not be making a worthwhile return on your investment and may want to find a way to reduce expenses or increase income. However, it’s important to note that cap rates typically correspond to level of risk for a property as well. All things considered with two alike properties, the property with the lower cap rate is bound to have a lower risk for return, while a higher cap rate implies relatively lower chances of return on a property investment.
Do I Need to Know My Cap Rate to Get a Loan?
The answer to the above question largely depends on what type of investment you’re looking into. Cap rates are most often associated with commercial real estate deals, and aren’t necessarily a major consideration in residential real estate transactions. In either case, knowing your cap rate can be very useful for investors who want to have a complete understanding of the financial side of their business. However – knowing it off-hand isn’t necessary to get a loan!
If you’re considering private financing for a real estate transaction, our loan origination team is standing by to discuss any deals you might want to run numbers on. Even if we can’t fund it, we’re happy to walk through options and point you in the right direction. Feel free to give us a call at 410-855-4600. To view terms you may qualify for, fill out our online rate calculator today!