Every investor should know how to calculate the cape rate for their rental property.
The capitalization (cap) rate is a commonly used method to determine if an income property is worth checking out.
It is a solid indicator of profitability. The cap rate of a property equals the net operating income (NOI) divided by the value of the property to arrive at a percentage.
Cap Rate = NOI / Property Value
For example, if a property was listed for $1,000,000 and generated a NOI of $60,000 the cap rate would be 6%.
What is NOI?
The net operating income of a property is the annual income generated after adding all the income collected and subtracting all expenses.
How do I calculate the NOI?
To calculate the NOI:
Add all income collected from operations.
This includes monthly rent, laundry income, parking income, etc.
Add all expenses from the property.
This may include Insurance, power, heat, water, garbage removal, snow removal, vacancy (at 5% of monthly income), maintenance, etc.
Subtract the expenses from the income to get your NOI
Income – Expenses = NOI
How to use CAP Rates for the purchase of your property
The cap rate is a great tool to help you determine what your purchase price should be.
When submitting an offer on a property you need to be doing all the numbers so you know what your absolute top price is for that property.
For example, from doing the numbers you know it does not make sense to purchase the property in question for over $775,000
Why? – if you purchase that property over $775,000 it brings your cap rate down to 4.7%. You are only interested in adding on properties to your portfolio that are 5% or higher.
So – when negotiating the property you know that if the price gets above that number, you will walk.
What are the cap rates of your current rental properties?
If you do not know, a good exercise is to do the numbers on your current portfolio as you would if you were going to purchase each property today.
How does your currently portfolio stack up to what you are currently looking for?
What is a good cap rate?
Personally, I am looking for 8% or higher.
What frustrates me is low cape rates have become the norm for realtors and investors. While some listing agents boast 4% cap rates, I would recommend not viewing a property unless the numbers show it producing a higher, more desirable cap rate.
Think about it this way, the interest rates are currently the lowest we have seen for quite some time. If you are struggling to pull off a 4% cap rate at the current interest rates, what type of cash flow return will that property generate with an increase in rates?
That is why I focus on finding great cap rates in properties that have great monthly cash flow.
When searching for investment properties what are you looking for?
Don’t waste your time with showings and agents until you do your numbers.
Have the proper tools in your tool belt to make the right investment decisions.