The capitalization rate, or cap rate, is the rate of return on a real estate investment property based on the income the property is expected to generate.
It is an important consideration for investors looking to buy rental homes.
Let’s look at an example.
A three-bedroom/two-bath single-family home is listed for sale for $200,000. You’ve done your research on the neighborhood and have determined that the home can command a monthly rent of $1,900. You’ve also viewed the home in its current condition and you have estimated that your annual expenses will be about $9,100.
In considering your annual expenses, you should take into account these items: annual real estate taxes for the property, property and liability insurance, any utilities that you will be paying, repair and maintenance costs; HOA dues, management fees and projected vacancy expenses.
In this example, we estimated annual real estate taxes at $4,500, insurance at $1,000, vacancy costs at $1,100 and maintenance expenses at $2,500 for a grand total in annual expenses of $9,100.
To figure out the cap rate, we are going to take the income that we expect the property to generate ($1,900 x 12 = $22,800) and subtract our annual expenses ($9,100) to get an expected annual net operating income of $13,700.
We then divide $13,700/$200,000 to get a cap rate of 6.9%.
Using the cap rate is a good way for a SFR investor to compare multiple properties in a given market against one another to see which one might offer the best rate of return.
The higher the cap rate, the better the annual rate of return. Based on the investor’s objectives, a home with a 10% cap rate might be a better investment opportunity than a home with a 3% cap rate. Keep in mind that higher cap rates can indicate increased risk as well. Investors will have to decide for themselves the minimum cap rate they are willing to accept. Is a 5% return sufficient or will a 7% or 8% cap rate be your floor?
In our example above, let’s say you’ve decided that the minimum cap rate that you are willing to accept is 7%. Take your annual net operating income/cap rate or $13,700/7% to get the amount you should pay for the property you are considering.
In this example, you would need to offer $195,715 on the listing to reach a 7% cap rate.
To review, the cap rate equation is yearly income/purchase price. Remember to factor in expenses.
It’s also important for investors to realize that this isn’t a fail-proof equation, as unforeseen expenses can occur or your estimates can be off. Make sure you have a cushion of funds after the mortgage is paid for unexpected expenses that could cause your cap rate to be lower than what you calculated.
Say, for example, the property sits vacant for longer than you anticipated or that a tenant causes expensive damage. It’s important that you consider your rate of return against worst-case scenarios to make sure that you don’t end up with a negative rate of return.
Cap rate isn’t the only thing real estate investors should consider when investing in single-family rental properties, but it is certainly an important one to recognize.