Real estate investing provides a fantastic way to diversify your portfolio with assets that are not tied to the stock market. Unfortunately, many new investors get intimidated by the complex terminology that experienced real estate investors toss around. One phrase in particular might be confusing to first-time investors: cap rates.
Investors who understand cap rates and how they factor in to a successful economic plan are able to make smarter investments than their competitors, because cap rates allow investors to calculate the potential returns from a specific property. This is an inaccurate science, but it’s invaluable for savvy investors who want to maximize the return on their investment. While the data provided by a cap rate calculation is unlikely to be exactly right, it should help a prospective investor understand how a single-family rental home will perform in the long term.
So, what is a cap rate?
Capacity rates, or cap rates, serve as a quick indication of a property’s capacity to recoup an investor’s initial outlay. This formula can be used for practically any type of real estate investment, from condos to single-family homes and is based on a simple calculation that compares the value of the property asset to the property’s net operating income.
Net operating income is the total amount of money the property will bring in over a set period of time minus all of the expenses that accrue over the same period of time. These costs include taxes, maintenance, management expenses, insurance and utilities, and any other outlays that are unavoidable parts of property ownership. It’s crucial to research local taxes, insurance and utility costs in an area to ensure an accurate cap rate calculation.
Once you have found the baseline net operating income for a rental property, you must subtract 10 percent from the total. This accounts for vacancies that are an inevitable part of rental property ownership. While it’s possible to cut down on the potential for vacancies by investing in areas with particularly strong rental demand, assuming a 10 percent vacancy rate ensures that you will not overestimate the property’s capability.
After you calculate your vacancy-adjusted net operating income, it’s a simple matter to divide that number by the upfront cost of the property to determine the property’s cap rate, which will be expressed as a percentage that reflects your probable annual ROI.
What constitutes a good cap rate?
A viable cap rate differs depending on the specific market where an investment is located. As a general rule of thumb, you want to aim for cap rates of at least 4 percent, according to NOLO. An acceptable cap rate will differ on the investment’s location and on the investor’s goals. If a home is located in an area with particularly high demand, a lower cap rate may be acceptable, because the home is probably going to see consistent occupancy and is likely to grow in value. In areas with less active markets, investors will want to seek homes with particularly high cap rates to ensure they recoup on their investment.
In any market, it is important to compare different homes to ensure you find the houses in that local that provide the highest cap rate. Otherwise, you risk purchasing a home that offers lower monetary returns than its neighbors.
How to stay ahead of cap rates
Obviously, a lot of shifting economic factors enter into cap rate calculations, and the data that results in an accurate calculation for one regional market will differ significantly from the information needed for a different place. With that in mind, investors can subscribe to market-specific cap rate data from RealtyTrac and Local Market Monitor, which will provide insight into an area’s average cap rate. That’s useful for investors who want to compare the cap rate of a potential acquisition against the average rates in a specific area.
While cap rates should not be the only factor investors look at when making a purchase decision, they are a valuable tool for assessing the potential value of different investments.
HomeUnion® makes it easy to invest in single family rental properties in a range of markets across the U.S. One of the data points HomeUnion® provides is cap rates, which helps investors judge the ROI on a potential investment property.