Get Access to 250+ Online Classes
Learn directly from the world’s top investors & entrepreneurs.Get Started Now
In This Article
You’re thinking of buying an investment property, and you’ve narrowed your list down to a few options.
How can you know which property will be the most profitable?
It’s a question that new and experienced real estate investors alike face.
Thankfully, there are several tools you can use to find an answer to this difficult question.
One of those tools is called capitalization rate, also known as cap rate.
The cap rate factors in the amount of income:
- you are likely to receive from your tenants
- the amount of money you will spend on expenses
- your overall rate of return
If you want to learn more about how cap rate can help you decide on whether an investment property is right for you, let’s get started!
What is Cap Rate?
Cap rate compares the property’s net income to the purchase price.
If you are considering buying a rental property, it is important to know the cap rate to figure out if the deal is likely to yield a good profit for your efforts.
As a new investor, you may think that if the amount of the rent your tenant will pay covers your mortgage payment, you are making a profit.
In fact, you have to consider other costs like:
- your investment amount
- other expenses
The real estate cap rate takes these factors into consideration.
Keep in mind that the cap rate does have its limitations.
For example, it does not take into consideration how much you are paying for your mortgage loan and other debts.
How To Determine Cap Rate in 4 Steps
You can calculate the cap rate by dividing the net operating income by the price of the property using this formula:
Cap Rate = Rental Income/Purchase Price
- First, calculate the annual rent
- Second, add up your annual expenses, such as maintenance, insurance, utilities, and management
- Next, subtract your annual expenses from your annual rent
- Finally, divide your net income by the purchase price of the property
What is a Good Cap Rate?
When you have the cap rate for any given property, you may be wondering what a good cap rate is.
According to Realtor.com, a cap rate from 4% to 12% is considered a good cap rate for real estate investors.
A capitalization rate of 4% is the lowest percentage most investors will consider for their rental property. Any rate lower than 4% can put you at financial risk if unforeseen circumstances occur, such as a major renovation problem or extended vacancies.
Cap Rate Example
Let’s look at an example of cap rate.
Let’s say you are thinking of buying a 2-family townhouse and you are charging each unit $1,000 per month in rent, that’s $12,000 per unit, per year.
That’s $24,000 in rent per year.
To determine the cap rate, next add up the yearly expenses.
If you pay $650 in tax, $300 for insurance, $500 for a property manager, $400 for routine maintenance, and $1,680 in vacancy losses, you have $3,530 in expenses.
You can now subtract your yearly expenses from your income. In this example, subtract $3,530 from $24,000.
Income – Expenses = Net Rental Income
$24,000 - $3,530 = $20,470
Thus, your net rental income is $20,470.
Next, divide the net rental income by the purchase price of the property.
If the townhouse price was $250,000, divide $20,470 (net rental income) by $25,000.
Net Rental Income/Purchase Price = Cap Rate
$20,470 / $250,000 = .081 (x 100)
Your cap rate is 8.1%.
Other Formulas to Keep in Mind
Cap rate is one of many tools that investors can utilize to determine whether or not a given investment property will be profitable.
Here are a few others to consider.
When calculated, the price to rent ratio will give you a number that indicates whether it’s cheaper to buy or rent a property in a specific market, which can help you determine if it’s the right market for you to invest in.
You can learn more about price to rent ratio here.
Net Operating Income
NOI is a statistic that evaluates a revenue-generating real estate property’s profitability.
The net operating income formula is quite simple:
Property revenue - operating expenses = net operating income
You can learn more about net operating income here.
Cash on Cash Return
Cash on cash return measures the income you could earn as a percentage of the cash you will invest in a property over a set period of time — generally one year.
You can find out more cash on cash return here.
The Bottom Line: Cap Rate
The cap rate is a simple formula that you can use to determine whether or not an investment property is worthwhile.
Remember, the higher the cap rate, the better the deal.
Most real estate investors will not touch an investment property with a cap rate below 4%, and they may look for an investment property with a cap rate closer to 12%.
By arming yourself with powerful tools like cap rate, you can set your investment property up for success now and into the future.