While it might seem straightforward to pinpoint a lucrative property initially, as your portfolio expands, you’ll require a more sophisticated approach driven by essential metrics. Among these metrics, the Capitalization Rate, commonly known as the Cap Rate, stands out as a crucial instrument in every real estate investor’s toolkit.
Cap rates, often hailed as the investor’s North Star, enable you to estimate and compare the potential returns on various commercial or residential real estate properties. Our focus today centers on residential rental real estate, specifically one- to four-unit multifamily homes designed for commercial or investment purposes.
Calculating cap rates involves a straightforward division of a property’s Net Operating Income (NOI) by its current market value. Yet, it’s essential to recognize that cap rates do not provide a comprehensive return on investment; instead, they offer an estimate of the time required to recover your initial investment in a property.
Let’s dive into the calculation of cap rates, commencing with understanding how to derive a property’s Net Operating Income.
Calculate The Property’s Net Operating Income (NOI)
To initiate the process, you must determine the Net Operating Income (NOI), which essentially combines a property’s income streams and deducts its expenses.
Begin by identifying the property’s total income, encompassing rental income, fees, and additional income streams it might generate. For example, consider a property that generates $5,000 per month in rental income without additional revenue streams. In this scenario, your total income for the property amounts to $5,000.
Next, evaluate the property’s total operating expenses, including property taxes, insurance premiums, repairs, and legal costs, along with potentially less apparent expenses like expected vacancies. While a common assumption is a 10% vacancy rate, local research can provide a more accurate estimate. For the property under consideration, total expenses could be $1,000 per month, accounting for a 10% vacancy expectation.
With this data, subtract the total expenses from the total income to determine the NOI. In our example, the property’s net operating income equates to $4,000 per month or $48,000 per year.
Divide By The Current Market Value
Subsequently, divide the net operating income by the current market value. While there may be debates among investors regarding the utilization of the current market value or the purchase price, most investors opt for the property’s current market value. In our example, suppose the property’s current market value is $480,000, resulting in a cap rate of 10%.
Convert Into A Percentage
Finally, transform the outcome of your division into a percentage by multiplying it by 100. In our case, this computation yields a cap rate of 10%, represented as 0.10 when multiplied by 100.
Cap rates serve as your guiding light for investment decisions. Nevertheless, it’s imperative to acknowledge that numerous factors can influence cap rates, including location, market size, asset stability, growth potential, and capital liquidity.
For instance, a property’s location can significantly impact its cap rate. Higher cap rates are often associated with higher-risk locations, while more competitive markets tend to exhibit lower cap rates. The property type, its stability, and growth potential play pivotal roles in cap rate determination.
While cap rates are frequently employed by real estate investors to evaluate the risk of acquiring commercial properties, they might not be as suitable for other real estate investment scenarios. In situations where, for instance, an apartment building hasn’t consistently generated income due to short-term vacation rentals, the cap rate formula may not accurately predict the investment’s value. In such cases, alternative models can offer more precise estimations.
Determining A Good Cap Rate
There is no one-size-fits-all definition of a “good” cap rate, as this varies based on property type and individual investment preferences. Generally, a higher cap rate indicates a higher-risk property with a shorter return on investment timeline, while a lower cap rate suggests less risk but a longer duration for recouping your initial investment.
Cap rates are an invaluable tool for comparing rental properties and gaining insights into potential returns on investment. They play an essential role in the decision-making process for real estate investors, guiding them toward lucrative opportunities and supporting the expansion of their real estate portfolios.
If you’re ready to transform your dreams of residential rental property ownership into reality, apply online today and explore how Rocket Mortgage can be your source for mortgages on investment properties.
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