Capitalization Rate or “Cap Rate” is a ratio used by real estate investors to determine the desirability or profitability of a specific property. This ratio compares the relationship between the property value and the potential income that property may produce as if you had paid cash for the property.
While there are certainly more sophisticated analytical tools we can use when evaluating rental properties, cap rate is a good quick reference tool used to assess whether or not a property is even worth considering.
We use this formula when we are working with our investor clients. Knowing property values and rental rates along with a good sense of average repair and maintenance costs and potential vacancy rates allow us to calculate a rough cap rate on the fly.
As we narrow down the properties our client is interested in, we can do a more precise calculation prior to making an offer on any properties.
Establishing Cap Rate
Cap Rate is established by dividing the Net Operating Income (NOI) of a property by the value of that property. The cap rate essentially shows the relationship between the property value and the potential income that particular property could produce. The higher the cap rate the more attractive the property is.
Net Operating Income NOI
Let’s look at the Net Operating Income half of the cap rate equation. NOI consists of all revenue from the property, minus any reasonable operating expenses. NOI is a pre-tax figure, appearing on a property’s income and cash flow statement, that excludes principal and interest payments on loans, any capital expenditures, depreciation, and amortization.
In order to establish Net Operating Income, you total the annual rents collected for a property, this is the Gross Income. Once this figure is established you would subtract the following expenses.
- Annual Property taxes
- Any Insurance
- Maintenance
- Repairs
- Vacancy rate
- Property management fees
Property Value
The other half of the equation is “value”, this is the price you paid for the property or the current value of the property. If you are looking at properties and have questions about value, your agent should be able to give you a reasonably good idea of what the property’s true value is.
Working Backwards-Using Cap Rate to Establish Value
Cap Rate can also be a helpful tool to use in order to determine your bottom line when evaluating a property you are interested in purchasing.
Let’s say you are interested in a property that is listed for $300,000. Your goal is a 10% cap rate on any property you purchase. Let’s say the NOI for this property is $27,000, which gives us a 9% cap rate, not bad but you want 10%. This means you would need to acquire this property for $270,000 in order to get your 10% cap rate.
Each situation and market are different but knowing that $270,000 is your bottom line helps you decide if you want to even pursue this property or if the price is too high for the return you’d see. In some markets, an offer that is 10% below asking price is a common practice while in other markets it would be a slap in the seller’s face. Each market is different and these are decisions investors need to make.
Other Methods
It’s important to note that cap rate looks at potential financial performance, not actual returns. In order to get a better idea of how a given property will perform, there are other methods of evaluating a property that will give you better results. Methods like cash flow analysis and cash-on-cash returns are potentially better metrics to use, assuming you know your numbers.
The vacancy rate, maintenance, and repairs all affect an investor’s bottom line and all three are fairly unpredictable. Controlling these costs without compromising the health and safety of your tenants is the key to long term profitability from rental properties.
In Conclusion
There are a number of methods investors can use to analyze an investment or rental property. Cap Rate should be just one tool in an investor's arsenal but it is an important one. Remember to use cap rate in the early stages of new property acquisition.
The key to successful investing in the residential real estate rental market is buying the property at a great price. This one key detail makes all of the other factors easier to work with and cap rate does a great job when you are looking for deals.
