Investing in rental properties can be lucrative, especially if you leverage your financing appropriately. However, do you know how much of that income is really profit?
Understanding how to properly assess rental property investments by using the right calculations essential. Every aspect of costs and potential gains must detailed to avoid losses. This article explains how to calculate capitalization rate—or cap rate—of a given property to help accurately determine its profitability.
What is a cap rate?
In determining the profitability of a real estate investment, the cap rate is the net operating income (NOI) of a property in relation to the property’s asset value.
The cap rate calculation is used to estimate the return on an investment.
To calculate the cap rate of a property, you simply divide the NOI by the value of the property. Here is an example based on one year of income and expenses:
$9,000 Gross rental income
-$900 Property management
$6290 Net Income
$6290 (Net income) ÷ $40,000 (Purchase price)= 0.157 or 15.7% Cap rate
This calculation will give you a percentage that indicates the annual return on your investment. Considering you might get just over 2% for the same amount in a money market account, the cap rate may look pretty attractive. However. There are many factors that affect the cap rate of a property over time.
The more detailed the better: We gave you a simple calculation to show how to get a cap rate. However, when you calculate this for your own property, take into consideration all income and expenses. Items often overlooked include HOA fees or extra cleaning costs in high turnover rentals.
Vacancy consideration: You should also account for vacancies in your cap rate calculation. 10 percent is a modest vacancy rate. This will take the monthly gross income of the example property from $750 per month to $675.
Why you should care about cap rates
In the future, you may want to purchase another investment property. Cap rates give you a valuable estimation of a potential property’s return on investment. This enables you to quickly compare several potential investment properties to see which one provides the best return before making a down payment or arranging financing.
Continuing to monitor cap rates as your investment changes
Perhaps you have an investment property with out-of-whack energy costs due to an inefficient AC system. Easy to do here in Hawaii where electricity costs are among the highest in the nation.
Examining your NOI early on enables you to identify changes you can make to increase profitability. Decreasing your net operating income improves cash flow, providing a buffer for expenses like a new PV system or to cover unexpected vacancies.
As a real estate investor, it’s helpful to be knowledgeable about your local market. We’ll continue to provide you with sales and rental price data from around the island.
When not to use a cap rate
As useful as cap rates are, there are several scenarios where they will not be effective. Some of these include purchasing a home you plan to live in, or purchasing a property to fix up and sell quickly. A cap rate should not be used as the sole determining factor when making an investment.
What can you expect from a cap rate?
Cap rates can vary widely by area, even within the island of Maui. However, as a general rule, a cap rate of 10 percent or more is good, though some investors are just fine with rates between 7 to 8 percent. This is a good time to consider a property’s projected long-term performance. What is the age of the property? Is the rental market demand stagnant or growing? Are there any major capital improvements on the horizon?
Cap rates are just one tool in evaluating and building your real estate portfolio. When we manage your property, we get to know it inside and out- literally! So when it comes time to move on to the next opportunity, our agents will have all of the data and in-depth knowledge to help you sell at the right price. And we’ll give you a nice commission discount you can factor into your profit!