Real estate is becoming an investment avenue for more and more people as companies such as HomeUnion® help individuals to enter a market that, even a few years ago, may not have been accessible to them. Online information resources, guides and even direct investment tools are just some of the ways individuals can become real estate investors in markets throughout the country.
This may be music to your ears, as real estate can be one of the best investments you can make.
While having a wide range of opportunities available at your fingertips is very attractive, it does create somewhat of a challenge …
How do you identify the best opportunities in the real estate market so you can make sound investments?
There are a number of factors that will play a part in determining the outcome of a real estate investment, including:
- Property type
- Condition of property
- Amenities near the property
- School district
- Job market
The key to becoming a successful real estate investor is identifying the properties that will bring the best return on investment. Doing so is not an easy task, though. While having the ability to invest in properties throughout the country certainly widens the net, it does make it somewhat more difficult to land the big fish.
So, how do savvy real estate investors make the best choices when comparing multiple properties? One of the best ways they do so is by figuring out a property’s cap rate.
What Is a Real Estate Cap Rate?
A capitalization rate (or cap rate) is a measurement that is used to determine the rate of return that can be expected through a real estate investment property. Investors use cap rate to estimate what the net income will be on their property.
The best part about cap rate is it is an equalizing measurement. In other words, it is a formula that works equally independent of the details of the property. The cap rate is a data point you can use to compare properties of different types (single-family home versus condo), different sizes and in different locations, for example.
This is the reason why cap rate is such a popular piece of information for investors. The formula only represents the expected yield of a property over time.
The cap rate is the estimate of your cash flow income, and in reality, is the equivalent of the net operating income (NOI) for your investment. If you purchased the property using cash instead of a mortgage, the cap rate will represent the return on your investment (ROI).
How Do You Calculate Cap Rate?
The cap rate formula is very simple. To figure it out, you just need to divide your NOI by your total investment into the property. The resulting number will be expressed as a percentage.
As an example, if your NOI is $5,000, and your total investment into the property was $40,000, your cap rate would be 12.5%:
- 5,000 ÷ 40,000 = 0.125
Simple enough, right? The challenge, of course, is that while it is easy to know what your total investment on a property would be, it’s not as easy to know the NOI. Let’s break down the steps for each.
1.) Calculating NOI
Figuring out your NOI is a three-step process. First, you need to calculate your annual income. If you already own the property, this will be simple, as you just need to multiple your monthly rental income by 12. If your monthly rent is $1,500, for example, your annual income would be $18,000.
If you don’t already own a property, this step will not be as straightforward. You’ll want to start by doing market research to figure out the best local real estate market to invest. Once you’ve done that, you can use an online tool to estimate the rental value of your residential property. Then, you can use this estimate as your annual income.
The second step is to subtract 10% of your total annual rental income. This accounts for a potential vacancy at your property. It’s always a good idea to build this into your cap rate so you can weather the storm if your property remains vacant for a period of time.
The last step is to figure out your net income, which is determined by subtracting all the costs that are involved in operating the rental from your total annual income. If you funded your investment with cash, these costs will include:
- Management fees
- Property taxes
- Utilities (if your tenant doesn’t pay for them)
- Maintenance costs
If you funded your investment with a mortgage, then you will also need to factor in your annual finance costs.
Here’s a detailed breakdown of how to calculate your NOI:
Using the example above, your annual income would be $18,000 (a monthly rent of $1,500 multiplied by 12 months). You would then subtract 10% for a possible vacancy (18,000 X 0.1), which would leave you with $16,200. Then, you would subtract the annual costs of operating the property, which could be estimated at …
- Management fees: $1,200 ($100 per month)
- Property taxes: $2,400 ($200 per month)
- Utilities: $1,200 ($100 per month)
- Insurance: $600 ($50 per month)
- Maintenance costs: $360 ($30 per month)
The annual total costs of $5,760 would be subtracted from the $16,200, leaving you with an NOI of $10,440.
Again, keep in mind that if you financed the purchase of the property with a mortgage, then you will need to also subtract the annual interest you will pay on the loan.
2.) Calculating Total Investment
Calculating your total investment into your property doesn’t include as many elements as your NOI does. To figure out your total investment, you need to factor in your costs for acquiring the property, including the purchase price of the home, closing costs and brokerage fees, as well as any rehab costs you incurred to get your property ready for rent.
For this example, we are again going to assume that you purchased your property using cash. If you financed the purchase through a mortgage, your purchase price would be replaced here with the amount of your down payment.
The elements of this could be:
- Purchase price: $80,000
- Closing/brokerage costs (2%): $1,600
- Rehab costs: $38,400
This would give you a total investment of $120,000.
3.) Calculate Cap Rate
Now that you have the NOI ($10,440) and your total investment ($120,000), it’s easy to calculate the cap rate.
- 10,440 ÷ 120,000 = 0.087
This scenario would give you a cap rate of 8.7%.
How Do You Use Cap as an Investor?
Understanding how to calculate cap rate is an essential tool for any real estate investor. Cap rate is perhaps the most effective way to analyze the relationship between rental income, operating costs and acquisition costs.
Cap rate allows you to compare multiple real estate investment opportunities to each other, even if those properties are in different locations, are different types and are listed for different prices. Ultimately, the cap rate is what should matter most to you, and not the monthly rental income.
Here’s an example:
- Property A brings in monthly rent of $2,700
- Property B brings in monthly rent of $1,100
At first glance, you might think Property A would be the better investment. But if Property A has a cap rate of 3.5, while Property B has a cap rate of 11.2%, then Property B will be the much better investment.
As long as you calculate cap rate the exact same way for all properties, you’ll be creating a true apples-to-apples comparison that will help you make a smart investment decision.
Once you start using cap rate, not only will you see how useful it is, but you will also begin to educate yourself about how important controlling costs are. In fact, how well you are able to control both the acquisition costs and the operating costs of your property could have the biggest impact on your bottom line.
What Is a Good Cap Rate?
The final piece of the puzzle is knowing what a good cap rate is. Without knowing that, it would be next to impossible to accurately utilize cap rate.
Generally speaking, most investors aim for a cap rate that is at least 10%. The acceptable rate for you could be lower, though. Some investors are completely fine with a cap rate that is between 7-8%, for example.
Ultimately, it all depends on your investing goals, your experience, whether you have multiple investment properties and the market in which your investment is located. Cap rate is highly local, so a 7% cap rate might be great in one market but terrible in another.
While there is no line-in-the-sand cap rate that you shouldn’t cross, the higher the cap rate, the better the return.
Use Cap Rate to Find a Solid Investment
Savvy investors will calculate the cap rate on all their potential investments to make the determination of whether a property would be a good fit for their portfolio. Cap rate is not the only analysis tool you should use, but it is a great way to weed out properties that don’t pass muster.
Cap rate is a great way to find the best investments for your goals, especially when partnering with a company such as HomeUnion®. When you’re perusing the many investment properties on our site, you will easily be able to calculate your potential cap rate by estimating the annual rent and operating costs.
To find out more, visit us online or call us at (866) 250-5610.