Here’s an easy-to-use cap rate calculator:
Before you use the calculator, you’ll want to be ready with data related to your property investment, including your operating expenses, vacancy rate, taxes, maintenance, and insurance costs, as well as your expected rental income.
Cap Rate Calculator
There are a number of ways that you can assess the value of a rental property when viewing it as a real estate investing. The primary focus should always be on what your overall objectives and what you expect to get out of this type of investment vs. an alternative. The cap rate, or capitalization rate, is one tool that can help you with this assessment.
Objectives are important when using any kind of investment calculation because it takes into account your risk tolerance and other factors. One person may buy a rental property with the plan to move there permanently once they retire, while another may invest purely to make as much money as they can. Someone else may invest because they want to diversify their investments. Being clear on your overall goals will help you make the best decision.
In addition to providing a cap rate calculator, this post will also go into detail about what cap rate is, how it’s calculated, and how it can be used.
What is cap rate?
Cap rate is an estimate of the rate of return you can expect from your real estate investment. It factors in the net operating income from your rental minus your operating expenses and any loss of income from vacancies. In other words, the cap rate is the ratio of your net operating income from the investment divided by your costs.
The cap rate can tell you whether the price a property you’re considering investing in makes sense. It can also guide you in determining a selling price for a property to ensure you make money from the investment.
Cap Rate Formula
Here’s the formula for the capitalization rate:
Cap Rate = Net Operating Income / Market Value of the Property
Here’s an example of a cap rate calculation:
Let’s say you have a property that is currently valued at $900,000. It’s a single-family home that you can rent for $3,500 per month. Thus, your gross annual rental income is $42,000. If your property is in a competitive housing area, the odds are that you’ll have a low vacancy rate. But let’s say the home is unoccupied for two weeks out of the year, or 14 days out of 365, which equals 3.8 percent.
The vacancy rate reduces your annual income by 3.8 percent, so your actual annual gross income from the property is $40,404.
Next, you need to factor in your operating costs. One thing to note is that in this calculation, operating expenses do not include your mortgage payments or depreciation.
Here’s a simple way to view it, with some sample expenses:
Annual gross income from rent after vacancy rate – $40,404
Minus taxes – $7,500
Minus maintenance – $3,500
Minus insurance – $8,100
= Net Income – $21,304
To get the cap rate, you divide the net income of $21,304 by the market value of the property: $900,000.
$21,304 / $900,000 = 2.4%
While it might seem obvious, the cap rate underscores how properties that are vacant for long periods of time are not earning money, just as properties that require a lot of ongoing maintenance and repair work will impact your return on your investment. Looking at the impact of vacancy rates alone can help you make a decision, once you factor in comparables, on whether you should lower the rent on a listing. Or, whether you want to invest in a property that’s going to require a lot of maintenance.
Cap rate can also underscore why it makes sense to outsource the management of a property to a professional property management company, which has the advantage of economies of scale when it comes to maintenance and making repairs on the property. In addition, a professional property management company will be well versed with the local rental market, comparables, and how much to charge for rent to optimize income while minimizing vacancy rate.
Just as home prices and rental costs reflect the market where a property is located, cap rates are also often consistent in a given market for comparable properties. So, looking at cap rates for a few comparable properties can help to guide you on how to price your property or how much to charge for rent, as well as whether an investment opportunity is worth it.
Interest Rates and Cap Rates
Cap rates tend to rise as interest rates do. The reason is that when interest rates go up, investments, such as bonds, which are tied to interest rate, can compete with housing investments.
Interest rates can also impact the home buying market because mortgages become more expensive for would-be buyers. If you can earn just as much money from a less risky investment than housing, you may opt for that, or expect a higher cap rate on a given real estate investment.
Similarly, just as lower interest rates make it easier for people to buy homes, expected cap rates on real estate investments may go down as interest rates go down, as more people view real estate investments as a good opportunity.
What’s a good cap rate?
The answer to the question of “What’s a good cap rate?” is not cut and dry. Again, it goes back to your objectives for making the real estate investment. Some might say a good cap rate is between 4-12 percent. However, different investors will have varying reasons for investing in a property, such as whether you plan to buy a property, rent it out for a short period of time, then remodel and flip it, or whether you want a steady stream of monthly income for the long term
When is cap rate especially useful?
As mentioned above, cap rate is a good metric to use in comparable situations, such as whether to buy one property in a geographic area or another. Or, whether to invest in real estate at all or in some other opportunity, such as the stock market.
Cap rate can also be used as a guideline based on risk tolerance for an investment. For example, investing in an up and coming neighborhood that has no guarantee of revitalization may have a higher cap rate – so a higher potential return, but also a higher downside than, for example, investing in U.S. Treasury bonds. In this case, the cap rate shows you the risk premium above and beyond the return on the bonds.
Generally, real estate investment opportunities with higher cap rates are riskier. Cap rates can also underscore whether certain aspects of buying and maintaining a property – such as maintenance costs or property taxes – are out of whack for what you expect in a return.
When are cap rates not helpful?
The drawback of cap rate is that it’s just one metric. For example, cap rate does not factor in mortgage payments, which are often the biggest expense when owning a property. In addition, the period that you intend to hold on to the investment has an impact on your overall return and costs, as well as the future value of your property.
Cap rates are also not useful if you’re buying a property that doesn’t have comparables, such as the largest house in the neighborhood or a unique, historical building.
Stil, cap rates can help you look at a real estate investment from a different angle, which can help to eliminate emotional or other biases you may have when looking at a real estate investment opportunity. And data, experience, and information always put you in the most optimal position when it comes to investing.
Work with the Experts in Real Estate Investing and Property Management
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