In some parts of the country, rental properties are in high demand. This is due to several reasons including people wanting to downsize, people wanting to live in a more walkable /livable area, and greater interest in trading away the cost and time of home maintenance for a maintenance-free lifestyle. Whatever the reason, the net result is that renters will always be a preferred or required lifestyle for a large segment of the population. As such, it pays to understand cap rates and how they are calculated.
In this blog post, we’ll explain what a cap rate is and why it’s important when buying or selling a rental property. So whether you’re a landlord interested in understanding what your property is worth or someone curious about the real estate market, this blog post has got you covered!
WHAT IS A CAP RATE AND WHY DOES IT MATTER FOR RENTAL PROPERTIES?
A cap rate, short for capitalization rate, is a simple but important metric for evaluating investment properties. It tells you the expected rate of return on a real estate investment, expressed as a percentage. As an example, let’s say you’re considering buying a residential property. You’ve run the numbers and estimated the market value of the property, after renovations, at $100,000. If you rent the property for $1,500 per month, then your annual rental revenues are $18,000. Your rent revenues, however, are not the return you earn on the property— your return is your rent revenues minus your operating expenses. Operating expenses include property management, maintenance expenses, and property taxes. Let’s say that these expenses add up to $8,000 a year; with $8,00 in operating expenses, your operating income will be $10,000, yielding a cap rate of 10%.
Why are cap rates important? Because the cap rate gives you a yardstick to compare different investment opportunities. For example, let’s say you’re considering two rental property investments. Property A has a purchase price of $100,000 and an annual operating of $10,000. Property B has a purchase price of $400,000 and an annual operating income of $20,000. Which one provides a higher return on investment?
At first glance, it might seem like Property B does because the net operating income is twice as high. But when you look at the cap rates, things look different. Property A has a cap rate of 10% ( $10,000 / $100,000), while Property B has a cap rate of just 5% ( $20,000 / $400,000). That means that Property A will generate twice the return on your investment as Property B. So even though Property B has a higher absolute return in total dollars, it’s a less profitable investment when considering the return against the amount of money invested.
Of course, there are other factors to consider when choosing an investment property. But the cap rate is a good place to start because it gives you a clear picture of the potential return percentage on your investment. And that’s why it’s a particularly useful tool for rental property investments.
EXAMPLES OF HOW THE CAP RATE CAN BE USED FOR REAL ESTATE INVESTMENTS
One way the cap rate can be used for real estate investments is to help you determine how much rental income you need to earn, or what your maximum operating expenses should be, in order to achieve a target cap rate. Let’s imagine that you are considering purchasing a property that has no rental history. The property is selling for $100,000, and your goal is to realize a minimum cap rate of 5%. You have obtained quotes from several property managers; the consensus is that property management costs plus maintenance are $6,000 a year. Your property insurance is $2,000, bringing you to a total of $8,000 in expenses. The initial rent you were targeting for the property was $1,000 a month, or $12,000 a year. But subtracting $8,000 from this leaves a net operating income of $4,000, or a 4% cap rate. You quickly realize that your rent will need to be on the order of $13,000 a year, or $1,083 a month, in order to achieve a 5% cap rate.
HOW YOU CAN USE THE CAP RATE TO MAKE MORE INFORMED DECISIONS ABOUT YOUR INVESTMENTS
There are a few things to keep in mind when using the cap rate.
First, it’s important to look at the cap rate in context. Meaning, you will want to compare properties with similar risks and rewards. For example, a property that requires significant renovations is likely to have a lower cap rate than a property that’s move-in ready. Likewise, a property that’s in a high-demand location such as near a desirable school district is likely to command a rent premium versus one that isn’t.
Second, it’s important to remember that the cap rate is only an estimate. Your actual return on investment may be higher or lower than the projected cap rate. Therefore, it’s important to do your due diligence and research properties thoroughly before investing.
By considering these factors, you can use the cap rate to make more informed decisions about which investment properties are right for you.
SUMMARY
So, what is a cap rate? In short, it’s the projected annual return on an investment property— after operating expenses— divided by the property’s market value. It matters for rental properties because it can help investors determine whether a particular property is worth buying.
YOU CAN ALSO READ: THE HIDDEN BENEFITS OF OWNING TURNKEY RENTAL PROPERTIES
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