When you invest in real estate you will come across various terms and calculations that you will need to get familiar with. How to figure out a cap rate is one of them. If you are purchasing smaller income properties or single family homes, the Cap rate calculation may not get brought up by your lender or real estate agent. As soon as you start investing in commercial or larger than 5 unit multi-family properties, it will become an important calculation, that the selling broker will be marketing to you, and the lender will be interested in.
The Cap rate is actually the Capitalization rate (abbreviated). It is used to determine the rate of return on an investment property. The formula can be calculated a couple of different ways, and if you are buying older properties to fix up and refinance, you will likely do an actual purchase price VS after renovation market price calculation.
The amount you pay for debt service is not factored into the calculation. I want to make it as simple as possible for the purpose of this post, and provide you with a couple of great links, in case you want more detailed information.
Cap rate = Net operating income divided by the price
Example: You are looking to purchase a 10 unit property. The price is $800000. The revenue it generates from rent, laundry, parking, storage, is $104000 per year, The expenses (not including debt service) are $30000 per year. The Net operating income would be $74000.
If we take $74000 divided by $800000 = 9% Cap Rate (annual rate of return, not including debt service).
As you can see, it is important to find out the actual net income. Make sure the expenses are realistic. We have often received lists of expenses from sellers, and as soon as we look at them, we know they are off. A couple of the most common ones to watch out for are: insurance costs and property tax. Do not be too conservative and lose deals, but on the other hand, do not be too liberal and lose money every year. If you are financing, the lender will be looking at your list of expenses, and will determine their own Cap rate (they will usually also look at a calculation based on market value). I will caution you not to depend on the lender to keep you out of financial trouble.
Check out the most accurate rental analysis calculator
Check out Investopedia for a really detailed explanation.
Check out Matt Larson’s Article on Nolo.com
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Until next time,
Design your landlord experience
Michael P Currie
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