How to Calculate Cap Rate on Investment Property

Is the rental property that you're thinking about purchasing actually worth the price? There are a number of tools that are used to make a good decision on a potential investment and for a rental property, nothing is more important than the cap rate calculation. This is the annual return that can be expected on an investment. Instead of relying on instinct or emotion, these cold, hard numbers provide the facts that prove a property can provide a great return one day.

What Is the Cap Rate?

In short terms, the cap rate is the annual return you can expect for the investment you're thinking about making. You get to this number by dividing the amount of net income you would expect to have against the actual expenses that you're going to pay each year.

In order to determine a future net income, you're going to need to estimate what your annual expenses are going to be. There are some key expenses that you won't want to forget about:

1. Vacancy Rates.

Most cap rate calculations will have a 5% to 10% cost of the annual rent that could be obtained as an expense because most properties don't have 100% occupancy every year.

2. Taxes.

Your real estate taxes will be an expense that is always going to be there. Don't forget to calculate a 3% increase every year on the amount of taxes that will be owed.

3. Insurance.

If you need a landlord's insurance policy, then this expense must be included in the cap rate calculation. Any general liability policies or other insurance needs must be added as well.

4. Repair cost estimates.

If there's one general rule about owning a home, it is this: stuff breaks. You'll need to plan for repairs and improvements to be made and include the amount of emergency repairs that may need to happen as well.

Now add up these expenses and get a real dollar figure.

You'll Want to Figure Out Your Income Too

Once this has been completed, take the number of rental units that you expect your property to have and figure out what the maximum amount of rent would be. If you rent 10 units out per month at a cost of $500 per unit, then your maximum income would be $5,000 per month, or $60k per year. Subtract the amount of expenses that you'd expect to have from the maximum amount of income you'd expect to have and you'll receive a net income figure.

Once that has been calculated, you'll want to divide that amount into the asking price of the rental property. If your net income is going to be $40k and the asking price is $625k, then your cap rate would be 6.1%.

If you have a minimum income amount in mind for your investment year over year, then you'll know what your maximum price will be and how much income to expect. If a cap rate is under 5%, however, you may wish to look for a better deal.
Posted on Oct 10, 2014


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