As a real estate investor, it’s important to know at all times if your investments are profitable. If you don’t, then you can quickly dig yourself a hole that could be extremely difficult or impossible to get out of.
While this can seem daunting, particularly if you’re new to real estate investing, it doesn’t have to be, and in this article we’ll be talking about how you can figure out the return on investment for your properties using the cap rate method.
The cap rate, or capitalization rate, is a term used by real estate investors to indicate the rate of return that is expected to be generated on a real estate investment. This is based on the income which the property is estimated to generate for the investor.
Knowing your cap rate is vital because it helps you to see whether a property will generate a worthwhile return for the time and funds which you have invested in it. This number is displayed as a percentage, and it’s generally a reliable way of estimating your return on investment.
There are a few different ways to calculate the cap rate for your investment property, but we’re going to talk about one of the most common and easiest formulas which you can use.
The “net operating income” is the expected annual income which will be generated by the property. So, for example, if you planned to purchase a property which would rent for $2,000 per month, then your net operating income would be $24,000, but you also need to take expenses into account.
This means you need to deduct anything required for the upkeep of the property such as insurance, taxes, property management fees, and estimated maintenance costs from this number.
While it can be tough to budget for everything, some people set aside 1% of the total property value for maintenance costs every year. Once you have your net operating income figured out, divide it by the current market value of the property to get your cap rate.
As an example of cap rate, let’s assume that you’re looking to buy a million dollar property, which you estimate will return you $70,000 per year.
($70,000 / $1 million = 7% cap rate)
So, how do you know if your cap rate is good or not? Unfortunately, the answer to this question is debatable, but most people look to have a cap rate that is somewhere between 8 and 12%.
While you might be tempted to call it a day if your investment falls within the “acceptable” cap rate range, there is a bit more to it than that, unfortunately. There are actually a number of factors which might cause you to pump the breaks on an investment, even if the cap rate is arguably decent.
Not all properties are created equal, and there are some other factors that could impact your cap rate assessment. Here’s a short list of some things to look out for if your calculated cap rate is too good to be true.
What kind of property are you investing in? A commercial property would likely warrant a much larger cap rate, because if the economy tanks you could be sitting on a sizable amount of debt with no one to rent your space.
A residential property would likely be a safer bet because people always need housing. A slightly lower cap rate may be acceptable here if the property shows potential.
Location is everything in real estate. So, before you decide a property is a great deal because of its cap rate you should evaluate where it is located. How difficult will it be to rent this property consistently? Are there enough jobs here to support a healthy rental economy?
What kind of rental is this? If you’re purchasing the property as a high dollar vacation rental, then your average rent will be much higher, but you might also pay more in maintenance costs than you would with a long term rental.
You should also make sure to factor in that your rental could end up sitting empty in the offseason, even if it’s in an otherwise attractive location, lowering your annual income.
Have you checked how many other properties are for rent in the area you plan to invest in? While your chosen rental may look like a great deal, it might not actually be if there are too many other properties to compete with.
Other landlords will continually drop their prices to stay competitive, and you could end up with either an empty property or one that is rented far beneath what you thought you were going to actually get for it. Buyer beware.
Cap rates are important for making sure that you aren’t taking on debt for an asset that won’t be able to pay for itself. It’s easy to get fooled into thinking that you’ve picked up a great deal, but there could be a very good reason that the property has been on the market for a year with no takers.
Using the cap rate method also allows you to easily compare properties to each other. If you’ve been eyeing more than one rental for your portfolio, then the cap rate could be the deciding factor that helps you see which properties earn more money for you.
If you’re purchasing properties with financing, then the cap rate is also valuable for determining how long it will take you to own the property free and clear.
In closing, the cap rate formula is a great tool for real estate investors that’s both easy to use and useful for seeing the bigger picture. You owe it to yourself to take advantage of every tool you have to make sure that your investments are successful, don’t ignore cap rates or you may quickly come to regret your new “asset”.
Make a note of particular homes you are interested in and see how long they stay on the market. Also, note any changes in asking prices. This will give you a sense of the housing trends in specific areas.
Lenders generally recommend that people look for homes that cost no more than three to five times their annual household income if the home buyers plan to make a 20% down payment and have a moderate amount of other debt. Down payment can fluctuate after sitting down with a trusted lender and going over your options.
Before you start looking for a home, you will need to know how much you can actually spend/afford. The best way to do that is to get prequalified for a mortgage. To get prequalified, you just need to provide some financial information to your mortgage banker, such as your income and the amount of savings and investments you have. This will tell you the price range of the homes you should be looking at. Later, you can get pre-approved for credit, which involves providing your financial documents (W-2 statements, bank account statements, etc.)
Real estate agents are important partners when you’re buying or selling a home. Real estate agents can provide you with helpful information on homes and neighborhoods. Their knowledge of the home buying process, negotiating skills, and familiarity with the area you want to live in can be extremely valuable. And best of all, it doesn’t cost you anything to use an agent – agents are compensated from the commission paid by the seller of the house.
Start looking at homes in your price range. You will see a lot of houses! It can be hard to remember everything about them, so you might want to take pictures or video to help you remember each home. Take your time finding the right home. Then work with your real estate agent to negotiate a fair offer based on the value of comparable homes in the same neighborhood.
Your real estate agent usually will help you arrange to have a home inspection conducted within a few days of your offer being accepted by the seller. This contingency protects you by giving you a chance to renegotiate your offer or withdraw it without penalty if the inspection reveals significant material damage.
Lenders have a wide range of competitively priced loan programs to help buyers. Every home buyer has their own priorities when choosing a mortgage.
Lenders will arrange for an appraiser to provide an independent estimate of the value of the house you are buying. The appraisal will let all the parties involved know that you are paying a fair price for the home.
As you can imagine, there is a lot of paperwork involved in buying a house. Your lender will arrange for a title company to handle all of the paperwork and make sure that the seller is the rightful owner of the house you are buying.
At closing, you will sign all of the paperwork required to complete the purchase, including your loan documents.
Curious about local real estate? So are we! Every month we review trends in our real estate market and consider the number of homes on the market in each price tier, the amount of time particular homes have been listed for sale, specific neighborhood trends, the median price and square footage of each home sold and so much more. We’d love to invite you to do the same!
You can sign up here to receive your own market report, delivered as often as you like! It contains current information on pending, active and just sold properties so you can see actual homes in your neighborhood. You can review your area on a larger scale, as well, by refining your search to include properties across the city or county. As you notice price and size trends, please contact us for clarification or to have any questions answered.
We can definitely fill you in on details that are not listed on the report and help you determine the best home for you. If you are wondering if now is the time to sell, please try out our INSTANT home value tool. You’ll get an estimate on the value of your property in today’s market. Either way, we hope to hear from you soon as you get to know our neighborhoods and local real estate market better.