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How to Calculate Cap Rate for Your Rental Property

Are you in the market for commercial real estate? Perhaps you have several investment opportunities to compare and could use some help in determining the most advantageous choice. That’s where the capitalization rate comes in.  

As a top-rated property management company in Montreal, the Ramfeld crew delves deeper into capitalization rate and its importance to real estate investors. Keep reading to learn how to calculate cap rate for your rental property.  

What Is the Capitalization Rate?  

The capitalization rate or cap rate is a valuation metric used to measure the performance of a rental real estate property. It estimates the potential return on investment calculated as a percentage of expected annual income to property value.  

Though the cap rate offers a fair estimate of expected returns and a good way to compare real estate investment values, you shouldn’t use it as the sole determinant of an investment’s profitability or viability.  

The cap rate overlooks several factors, such as future cash flows from property upgrades, the time value of money, and account leverage, among others. It also refers to the property value assuming a cash purchase without factoring in any mortgages or associated financing.  

The Importance of Cap Rate  

The capitalization rate helps investors gauge the profitability of a property investment. The rate comes in handy when comparing different potential investments and understanding how they operate as businesses.  

For example, you can expect to pay more upfront for a real estate property if it generates a higher rate of income or has fewer expenses. Thanks to the cap rate, an investor can get a clear picture of his or her expected return on investment and potential annual income stream.  

The cap rate also helps mitigate risk by offering a clearer view of operating expenses, helping you to identify areas of overspending that you can optimize for greater profit. For example, you can invest in an efficient HVAC system to minimize unnecessarily high operating costs.  

How to Calculate Cap Rate  

The following steps break down how to calculate cap rate for your rental property:  

  • First, establish the sale price of properties you’re considering for purchase.  
  • Then, find out the property’s net operating income (for an apartment building, this will be based on the annual net operating income.)  
  • Net operating income equals gross income minus operating expenses (property management expenses, taxes, utility bills, HOA fees, insurance, and more.)  
  • Finally, calculate the capitalization rate by dividing the net operating income by the property’s sale price and multiplying by 100 to get it as a percentage.  

Once you calculate the cap rate of a few properties like the one you intend to buy or sell, take the average of the numbers. Then, divide your property’s net operating income by the average cap rate to get your property’s relative market value.  

If you end up purchasing a real estate investment property, you’ll probably also have an expert do an appraisal. The cap rate will still come in handy when gathering information on your investment’s initial market value to make an informed decision.  

Cap Rate Example  

Let’s say you plan to purchase a real estate investment property valued at $320,000, and the property has an expected monthly rental income of $4,125 ($49,500 per year). Also, assume the following monthly operating expenses:  

  • Property taxes: $320  
  • Utilities: $150  
  • Insurance: $100  
  • Property management: $300  
  • HOA fees: $130  

Total monthly operating expenses: $1,000  

From the above, the monthly rent of $4,125 minus the monthly operating cost of $1,000 gives you a monthly net operating income of $3,125. Multiply this by 12 to obtain a yearly NOI of $37,500.  

Dividing the annual NOI of $37,500 by property value ($320,000) equals an 8.5% cap rate.  

On the other hand, if you already own property and plan to sell but don’t know how to value it, you can use the cap rate to assess your investment’s market value.   

Say properties comparable to yours have a cap rate of 10%. If your property has an annual net operating income of $42,000, your property’s market value will be $420,000.  

What’s a Good Cap Rate?  

A good cap rate varies depending on the investor and the property. Generally, market analysts consider cap rates that fall between 4% and 12% good.   

However, consider other factors when investing in rental properties, such as the potential change in cap rate following improvements to a piece of property to increase income or decrease operating costs.  

If you’re a first-time real estate investor with capital constraints looking to purchase a rental property, you would prefer one with a higher capitalization rate because you’ll enjoy lower upfront costs and decent returns relative to the purchase price.  

Now that you know how to calculate cap rate for your rental property, are you preparing to sell your property? If so, a lower cap rate would imply that your property has a higher overall value, which increases the likelihood of getting a decent amount of money from selling the property.  

When comparing cap rates, you must choose rental properties similar enough to the investment property you have in mind. For example, if you have your eye on a 12-unit apartment complex, you’ll want to base your calculations on similar-sized properties.  

Using large or smaller properties will skew your calculations.  

Any shrewd investor will consider a property’s current cap rate and its projected long-term performance. For example, investing in a large real estate market with a steady rise in rental demand carries less risk than investing in a smaller market experiencing slow-paced growth.  

Because of this, an investor may settle for a cap rate of 7% or less in a large market but reject the same rate in a smaller market.  

When Should You Use Cap Rate?  

Even though the cap rate has various limitations, it still comes in handy when you need an overview of a rental property investment’s potential return on the fly. It also helps to note that the cap rate’s suitability varies according to geographic location.  

For example, a good capitalization rate in an urban environment will differ from a good one in a rural or suburban area. Perhaps the most ideal time to use capitalization rate arises when selecting from multiple real estate investments for purchase.  

In such a case, the cap rate can prove effective in assisting you in determining which investment to choose. With the cap rate, you can quickly and effectively compare real estate investments without worrying about factors like unstable market value/purchase prices and rental incomes.  

The cap rate also comes in handy when you need to search for real estate trends and patterns. By collecting data on property cap rates within a specific location over a particular duration, you can generate a market profile that shows any periodic changes in the profitability of real estate.  

As a real estate stakeholder or investor, research that arms you with knowledge of present and historical cap rates can help you increase your overall expertise and understanding of markets that interest you.   

For example, studying cap rate trends and patterns can help you predict property markets anticipated to thrive. Similarly, a recent upward trend in cap rates means that you can expect a higher return on investment in that area with time.  

When to Avoid Using the Cap Rate  

As mentioned above, the cap rate has several use cases, but you shouldn’t use it in certain situations. For example, the cap rate proves effective when estimating the best return for a property you intend to rent out.   

However, it might not yield optimal results when calculating the return on properties you plan to flip or for short-term investments you intend to sell shortly after purchasing.  

What Is Cap Rate Compression?  

Real estate, like most investments, is not always perfectly stable. Property values can fluctuate depending on factors like the neighborhood, vacancy rate, and the general market.   

If a property value goes up, for example, dividing the annual net income by the purchase price lowers the cap rate. This cap rate reduction or compression sparks debate about whether the compression indicates lower or higher risk.  

Who Is the Cap Rate Important to?  

You know how to calculate cap rate for your rental property. But who needs it the most? A real estate investor looking for their next asset will find the cap rate quite useful.   

That said, most home buyers will find little to no use for the cap rate. A home buyer won’t typically want to rent their property, so they’ll focus more on property value.  

The average home buyer wants to find a solid deal with the potential to profit when they sell their home. However, someone looking to make a return on their investment will care about the property’s current market value, operating income, and other factors.  

An investor may also want to hold on to their property to maintain a recurring income stream.  

In such cases, the cap rate can help the investor compare the rental property against comparable properties in the area and determine whether they should hold on to their investment for purposes of income generation.  

Potential buyers and lenders can also use the cap rate when negotiating for financing.    

Is Cap Rate the Same as Return on Investment?  

While ROI refers to any number that shows an investor how much money they’ll earn compared to their investment, the cap rate shows how strongly a property has the potential to create a substantial ROI. That said, the cap rate differs from ROI.  

The Bottom Line  

The cap rate helps investors quickly and conveniently select the most optimal real estate investment from a set of investment options.  

Although it is a useful metric when looking to invest in real estate, it has several limitations. You should use it alongside other investment analysis techniques such as cash-on-cash return, Net Present Value, and Internal Rate of Return. 

Trust Ramfeld for Your Real Estate Needs  

Now that you know how to calculate cap rate for your rental property, you can make an informed decision about real estate investment properties. You still need a seasoned real estate expert by your side. Count on Ramfeld for tailored solutions to all your real estate needs.  

Our clients turn to us for:  

  • Property management  
  • Leasing  
  • Project management  
  • Asset Optimization  

Need help managing your expenses? Reach out for expert help.   Call Ramfeld at (514) 745-6106 to discuss your project and find out how we can help. We stay committed to enhancing the real estate investment process.

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