Investing in real estate can provide an avenue for continual passive income, and it can also be the cornerstone of long-term wealth building strategy. However, before shopping for potential opportunities, it’s critical to understand how to measure returns. One of the most common methods is using cap rate to determine a potential rate of return.
How can cap rate show you how much your investment property could pay back over time? Moreover, what is a good cap rate for rental properties? By knowing how to calculate cap rate and what factors go into it, you can make educated decisions about which properties fit your overall goals.
Definition of Cap Rate:
Cap rate is short for “capitalization rate:” a common calculation used to show the rate of return on any given real estate investment. Although it is not the only method, investors use to determine how much they could get back from their property, determining a good cap rate for rental property – like those in a real estate auction – to find the options with the best long-term returns.
It’s important to note that calculating a good cap rate for rental property does not include mortgage financing. Instead, cap rate simply measures the potential for return on the value of the home. For those who are planning to purchase their investment with a loan, it’s important also to consider the cash-on-cash return rate.
Beyond finding a good cap rate for rental property, calculations investors use to determine rate of return are the band of investment model and the Gordon model. While the band of investment method can be helpful to determine returns if multiple investors are involved, the Gordon model projects the growth of your net operating income over multiple years.
How to Calculate Cap Rate:
There are two ways to calculate cap rate for rental properties:
The first values the return against the current market value:
Cap Rate = Net Operating Income (NOI) / Current Market Value
The second values your return based on how much you purchased the home for:
Cap Rate = Net Operating Income (NOI) / Purchase Price
Which one helps you find a good cap rate for real estate? Of the two options, the first is most commonly used for investors. The first option gives investors a better understanding of their actual rate of return on their rental properties, instead of basing income off an outdated figure. Property values change every year. As a result, using purchase price to predict future gains might negatively skew your results.
Examples of Cap Rate in Use:
Before shopping for investment properties, the cap rate can help project the opportunity value. But what is a good cap rate for real estate?
As an example of a good cap rate for rental property: Let’s say an investor is looking to invest in two different foreclosure properties. One property is valued at $285,000, while the other is valued at $325,000. After the insurance, association fees, and setting money aside for maintenance and repairs, their net operating income (NOI) could be $21,000.
On the first property, their cap rate would be 5.96 percent:
Cap Rate = $21,000 / $285,000
On the second property, the cap rate would be 6.46 percent:
Cap Rate = $21,000 / $325,000
With an understanding of the potential return rate on both properties, investors can determine which one represents the best option for their portfolio.
What is an Acceptable Cap Rate for My Property?
One of the challenges of purchasing investment real estate is trying to understand the rate of return. Like any security, returns are never guaranteed, and investors could lose value over time for a variety of reasons. This is why many investors use cap rate to help them determine the growth opportunities of their passive income investment. What is a good cap rate for a rental property?
Unilaterally, there is no one single good cap rate for real estate. Instead, cap rate helps investors determine the amount of risk they are taking on.
Using the previous example of the two properties: the first property had a cap rate of 5.96 percent, while the second had a cap rate of 6.46 percent. If an investor was looking for a longer-term option as a passive investment with stable returns, the first property had a good cap rate for a rental property. At a lower cap rate, investors may be able to project longer-term appreciation.
Comparatively, the second property represents a slightly higher risk because it presents a lower chance of appreciation. In addition, higher cap rate properties also present a risk of losing income through non-vacancy. On the plus side, the higher cap rate also represents the potential for a higher return. If you are not risk averse, the higher number could represent a good cap rate for rental property.
Can You Change Cap Rates?
One of the positives of using real estate as an investment vehicle is in the control buyers have in improving their opportunity. Owners can “force appreciation” on their properties through compressing cap rates for rental property.
Experienced real estate investors can drive a good cap rate for their rental property through first understanding real estate trends in the marketplace. Properties that have a higher cap rate but are in desirable locations can have better odds of “compressing” to a lower rate.
From there, property renovations can help bring the property value up and attract renters. Charging more for rent improves your net operating income, which drives a good cap rate for rental property and presents a better long-term return.
Several other factors can also go into growing a good cap rate for rental properties and ultimately improving your rate-of-return. Before buying any property, consider the structure’s age, the property type (single home, duplex, or other multi-family home), and the rental market in any given area. Through managing all the factors that go into purchasing a rental property, you can make a smart decision about how much risk to take on by investing in real estate.
Both new and experienced investors rely on cap rate to help them understand which projects can present the best options for their long-term goals. Through knowing how to determine a good cap rate for rental properties and how it can change over time, you can find real estate that works for your portfolio at a good cap rate that makes sense for you.