Making wise residential real estate investments requires a firm grasp of certain financial concepts. If you're overwhelmed by all the formulas, metrics, and advice out there for evaluating potential properties, you're not alone. Unfortunately, there is no one-size-fits-all calculation you can use to decide if an investment is right for you. However, by learning about how and when to use various valuation tools, you'll arm yourself with the knowledge you need to pin down the methods that will work for each prospect you encounter.
One of the most common measures of a property's investment potential is its capitalization rate, or "cap rate." The cap rate is a calculation of the potential annual rate of return—the loss or gain you'll see on your investment.
There is more than one way to calculate the cap rate, but we'll look at the most common here. The basic formula is:
Cap Rate = (Net Operating Income)/(Current Fair Market Value)
Let's break that down:
Net operating income: Your net operating income is your gross rental income (the total amount of money you receive from rent) minus your operating expenses (such as payroll and costs of repairs). To arrive at this number, do the following:
Current fair market value: You can use either the asking price or the price you'd offer.
Example: You're considering a two-bedroom house that's listed for $325,000. The current tenants pay $2,000 per month. Gross rental income is 12 (months) x $2,000 (monthly rent) = $24,000.
You anticipate annual operating expenses to be $5,800: $3,800 in property taxes and $2,000 in maintenance and other expenses.
Your estimated net operating income is $24,000-$5,800 = $18,200.
You then divide your net operating income by the property's current fair market value (we'll use the list price of $325,000) to get the cap rate: $18,200/$325,000 = 5.6%.
If your estimates are correct, this two-bedroom property would give you a cap rate return of 5.6%.
The cap rate calculation above assumes that you're receiving full rent each month—in other words, that the property is 100% occupied 365 days of the year (and that your tenants keep up with the rent). While 100% occupancy might happen regularly for a single-family home, it's less likely for a multiunit building with more turnover. So, whenever possible, you'll want to account for a less-than-100% occupancy rate when calculating your cap rate. Here's how:
Adjust the formula for net operating income to the following:
Net Operating Income = [(Gross Rental Income) x (Occupancy Rate)] – (Operating Expenses)
Most real estate investors build a 5-10% anticipated loss of rent into their calculations. So, if you were to assume a 90% occupancy in the above the example:
Net operating income = [($24,000) x (.90)] - $5,800 = $15,800. (Note that a 10% reduction in occupancy results in $2,400 less net income.)
Cap rate = $15,800 / $325,000 = 4.9%
When you consider reduced occupancy, the two-bedroom house now has a cap rate return of roughly 4.9%, making it a slightly less attractive investment.
The cap rate is a helpful metric when you're assessing a property that you expect to yield regular, relatively predictable income. For example, you'd want to calculate the cap rate for a 4-unit apartment building occupied by tenants with year-long leases.
You'll want to calculate and compare the cap rates of similar potential investment properties you're looking at. For example, if you're weighing the pros and cons of two duplexes located in the same downtown area, comparing their cap rates can help you determine which property will be a better addition to your portfolio.
Knowing the cap rate of a potential investment also helps you decide if the asking price is reasonable—if it's overpriced based on your cap rate calculations, you might be able to negotiate a lower price.
Calculating the cap rate of a property isn't particularly useful if you're planning to flip it, offer it as a vacation rental, or rent it out on a short-term basis. When you flip a property, one of your goals is to hold onto it for as short a time as possible—making the cap rate's 12-month frame of reference less relevant. For vacation or short-term rentals, you're likely going to experience swings in income and occupancy, not to mention operating expenses that fluctuate due to seasonal maintenance or repairs resulting from high tenant turnover. These factors combine to affect your net operating income, which in turn results in an unreliable cap rate calculation.
Also, the cap rate is calculated on the assumption that you're paying all cash for a property—not taking out a loan. Therefore, it doesn't take into account any costs associated with a mortgage, such as interest or points paid. It also doesn't take into account the other costs of acquiring the property, such as closing costs and brokers' fees.
When you're looking to buy an investment property, most of the time you want to see a higher cap rate. The higher the cap rate, the better the annual return on your investment. If you are looking to make at least a certain percentage of income off your investment each year, you should let that drive your decision to invest. You can divide your calculated net income figure by your target cap rate to determine the price you'd be willing to pay for a particular property.
The "cap rate" you should buy at depends on the location of the property you are looking to buy in and the return you require to make the investment worth it to you. In other words, you'll want to gauge your aversion to risk. For example, professionals purchasing commercial properties might buy at a 4% cap rate in high-demand (and therefore less risky) areas, but hold out for a 10% (or even higher) cap rate in low-demand areas. Generally, 4% to 10% per year is a reasonable range to earn for your investment property.
Continuing with our two-bedroom house example from above, dividing the net operating income by a minimum acceptable cap rate of 5% will give you the top price you would be willing to pay:
$15,800/ 5% = $316,000. Because the current asking price is $325,000, this would not be a good investment for you—you'd be paying $9,000 more than you should to get your goal cap rate.
Whatever rate of return you are aiming for, make sure the projected income leaves you with a healthy amount of cash after the mortgage payment has been paid. If you have a tenant who doesn't pay for a few months, and the cap rate on your prospective property is 2% or less, your investment property might quickly become a liability. Be sure to consider worst-case rent loss scenarios when calculating your potential return—that way, you'll have a good sense of whether you can afford to carry the property when it's unoccupied.