In your bid to go into real estate investment, you find some unfamiliar terms used by industry analysts. An example of such words is the cap rate or capitalization rate.
Capitalization rate deals with the percentage of financial returns on a particular real estate investment. It tells you how soon you will get back the money you put into the investment. It is pertinent to check the cap rate of any investment you’re looking to take up. The cap rate would help in making prudent investment decisions based on the investor’s financial plan.
When an investor buys a rental property, they get manual returns from the property through rent. The rent on that property becomes the basis for determining the potential cap rate of the investment.
A rental property cap rate calculator computes the capitalization rate for an investment. Following are useful tips on what a cap rate entails and how you can calculate one.
What Does the Term “Cap Rate” Mean?
The cap rate of an investment property refers to its ratio of income to value. The gain on the property is calculated annually. The cap rate is essential to be able to make accurate financial plans on your investment. It is a basis for comparing the worth or value of a real estate property. For instance, a property that has a higher capitalization rate is likely to cost more.
However, note that capitalization rates are calculated assuming there are no debts to service. The cap rate calculator, unlike the cash flow rate calculator, doesn’t account for the mortgage.
Cap rates are usually calculated using properties that have been sold six months before or earlier.
How to Figure Out the Cap Rate?
In using the car rate formula, you’ll need to ascertain the expected income of the investment. Begin by considering the selling price and regular revenue of other comparable assets around. It might not be so easy to discover the earnings of others’ investments. You could talk to your estate broker to help you out with the numbers.
After getting the cap rate for similar assets, you can apply the values to your investment. You could use a real estate cap rate calculator using a cap rate formula. A well-used capitalization rate calculator would help in pricing your asset using similar properties.
Understanding the Cap Rate Formula
A real estate cap rate calculator is necessary to estimate the financial worth of your property. You’ll also need the calculator in case you’re applying for a loan. Take note of the following in determining the cap rate of your rental investment.
- What is the selling price of a similar property?
- What is the annual net rental income of the investment? Subtract the projected expenses from the annual net rental income without including mortgage fees.
- Divide what you get from (b) above by (a) the property’s selling price. The result is the property’s capitalization rate.
More simply, subtract operating expenses from gross income to get the net income. Divide the net income by the selling price, and you have the cap rate. Pretty straightforward.
Do the above calculation for more than one similar property, and take their average.
Then, divide your investment’s projected net operating income by the average cap rates of other assets. What you get is the market value of your rental investment.
You’ll eventually need to get professional services to estimate your investment. You can check out this rental property cap rate calculator. Applying the formula yourself could give you an idea of what you’re considering.
The cap rate will inform you of the amount of time (in years) it would take to get back your investment. A 10% cap rate would take about ten years to give back its original investment.
What Makes a Good Capitalization Rate?
Whether a cap rate is reasonable or not depends on two things. The first factor is the general market situation; the second is whether you’re the seller/buyer.
A rental property with a higher cap rate would generate more income than a lower one. The payment implied here is the net operating income.
Cap rates also project the amount of risk involved in an investment. Higher cap rates generally mean higher stakes, and a lower cap rate implies lower risk.
For an investor who wants to sell a property, a lower cap rate would benefit you. Lower cap rates mean the market worth of the investment is more. For a buyer, a higher cap rate might be preferred because of the lower initial costs.
In using the capitalization rate calculator, ensure that the compared operating are comparable to yours. For instance, don’t factor in the operating figures of a skyscraper for a seven-story facility.
An Example of Cap Rate Estimation
Suppose you’re looking to buy a rental property that’s worth $ 800,000. Make proper findings on like facilities in similar geographical areas that are operational. Subtract the value of their operating expenses from their net income. If the resultant value you get is $ 160,000, the capitalization rate is 5%.
With a cap rate of 5 % projects using current market trends, investors would recover their investment in five years.
What about the case of a seller who wishes to know their property’s cap rate? The sellers can equally use the cap rate calculator in valuing their property.
Find similar properties that could be compared to your rental property, which have been recently sold. Fix those figures into your rental property cap rate calculator. The NOI of your property divided by the cap rate gives the worth of your property.
Let’s take your rental property’s net operating income is $ 60,000 every year. A cap rate of 5 % would value your property at $ 1,200,000.
Knowing the cap rate of a rental property you’re considering allows you to compare different offers.
Note, however, that cap rates are based on prevailing market prices, projections. And that means that unexpected events could tamper with the eventual turnover of your rental property. Cap rates calculations apply to simple income stream properties. You may need a more complex analysis to value assets with unreliable income generation sources.
There you go. You’re free to use a rental property cap rate calculator to evaluate that investment you’re considering.