Estimating Capitalization Rate
Two words can make or break an investor’s decision to buy their next rental property: cap rate. Cap rate, also known as the Capitalization Rate, is the perfect ratio to determine the potential income for a rental property. Instead of looking at only the monthly and annual income, cap rate takes a broader look at the costs and expenses that occur with owning a rental property and gives a better sense of the overall quality of the investment. In a recent article from realtor.com, Bruce Ailon, a realtor and attorney from Alpharetta, GA is quoted as saying, “Cap rate is both a measure that tells you how much you are earning on the investment, and a proxy for determining the risk of an investment.”
Finding the cap rate can be broken down into three simple steps.
1) Calculate the property’s annual rent
Calculating the property’s gross annual rent is simply taking the rent your tenants pay you each month and multiplying it by twelve to get your gross annual rent. This is the rent you collect before subtracting annual expenses for managing the property.
2) Subtract the annual expenses
Once you’ve calculated your gross annual rent, you’ll need to subtract your annual expenses. These expenses include utilities, maintenance, and any repairs that are required. After you’ve subtracted your annual expenses you have your net annual income of the property.
3) Divide net income by purchase price or market value
Now that you know the amount of your net annual income from the property, you’re ready to calculate your cap rate. To find the cap rate, you’ll need to divide the net income by the purchase price or current market value of the property.
To give an example, if a property is providing monthly rental income of $1,000 then the annual income will be $12,000. Pretty simple right? The next step is to determine expenses and subtract that from the annual income. Continuing with the previous example above let’s say that the example property has yearly expenses of $3,000 leaving a net income of $9,000. Now that net income has been determined, the investor can divide net income by the purchase price -which for this example is $125,000- giving the investor a final cap rate of 7.2 percent. This represents the expected annual return on investment for that property.
According to the same realtor.com article, most investors look for cap rates in the 4-12 percent range, with 4% being the absolute minimum for a potential rental property. Any property with a cap rate lower than 4% has greater potential for a loss if there are unforeseen maintenance issues with the property, or long periods without tenants living in the property. By staying in the 4-12% cap rate range, investors can better estimate their returns and choose properties that provide a higher quality and less risky investment.
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