What is a Good Cap Rate for a Rental Property?
What is a Cap Rate?
The capitalization rate also known as cap rate is the term used in real estate to indicate the rate of return expected to be made on a real estate investment. It is a projected value based on the income which the property is estimated to generate for the real estate investor.
The cap rate helps to see whether the property will create a good return for the time and the cost in which the investor purchased the property. It is a convenient and quick way of estimating an investor’s return on investment.
What is the formula for the Cap Rate?
Cap Rate is net operating income (NOI) divided by the present value of the property.
CAP RATE = Net Operating Income / Present Value of the Property
CAP Rate Breakdown
NOI: To get the NOI, start with the estimated annual rental income of the investment property and factor in the potential vacancies and all estimated costs associated with operating the property such as the taxes, insurance, management costs, maintenance cost, and others. If the property is purchased through a loan, the debt and mortgage expenses are not considered in the calculation as cap rates treat each property as if it is an all-cash purchase.
Present Value of the Property: Purchase Price of the Property (First Year) or the Current Market Value of the Property
You are planning to purchase a property worth $106,000.00. The estimated monthly rental of the property is $1,100.00. The property has an annual tax of $1250.00, $640.00 for annual insurance, maintenance cost $390.00, and a management cost of $1320.00. The vacancy rate in that area is around 6%. Your monthly mortgage is $455.52
You get your annual gross income by multiplying the monthly rental by 12. Then you add all the property expenses (annual tax, insurance, maintenance cost, and management cost) and factor in the vacancy rate which is 6%.
You will get the NOI by subtracting the total property expenses and the vacancy cost from the total gross income of the property.
NOI = ($1,100x12) – (($1250 + $640 + $390 + $1320) + ($1100 x 12 x .06)) = $8,808.00
CAP RATE = $8,808.00/$106,000.00 x 100%
CAP RATE = 8.31%
How to use a cap rate in a rental property?
The cap rate can be in many ways such as in property analyzation and getting a better grasp on the investment market.
The simple concept of cap rate when it comes to the property investment or your rental property is the higher the cap rate, the cheaper the property, and the lower the cap rate the more expensive the property.
What is a good cap rate?
Well, it depends. As there is no clear answer to that since it depends on the investor. It depends on the investor’s goal.
Most real estate investors would consider 10 percent or better as the ideal cap rate. But others may do well in 7 to 9 percent cap rate.
For cap rates lower than that, it a pure gamble as you are betting that the market will appreciate in the future or hoping that the investment will be okay in the future.
But it depends on the investor.
Understanding the cap rate and its function is one of the ways to become a successful real estate investor. It can help you pick a market, a type of property, specific criteria for investment, and on deciding to hold or sell a property.
The idea of the cap rate is mathematical, but you need to understand it to understand the real investing industry.
Put this learning to use. Comment down below how you use the cap rate in your rental property.
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