If you're new to real estate investing, or in particular new to rental agreement investing, you may not be familiar with the concept capitalization rates, or cap rates. To summarize, cap rates are used to estimate the value of a rental income-producing property, such as an apartment building, based on the amount of income it can theoretically produce.
Part I: How to Calculate Cap Rates
The raw math involved in calculating cap rates is extremely simple. Arriving at the numbers to use, however, occasionally proves more complex.
Quite simply, the formula for calculating a cap rate is:
Annual Net Rental Income / Purchase Price = Cap Rate
So, if the net rental income from a duplex over the course of a year is $12,000, and the purchase price is $100,000, then $12K/$100K = .12 or a 12% cap rate. So far so good?
Slightly more difficult is determining the net rental income (also referred to as net operating income or NOI), because expenses and vacancy rates are sometimes erratic and unpredictable. Let's revisit our example above, for the duplex with $12,000 net rental income; let's say each unit in the duplex rents for $750, for a gross monthly rental agreement income of $1,500.
First, let's multiply that $1,500 by 12 months, for an annual NOI of $18,000. Then, we have to subtract out the average vacancy rate; let's assume a vacancy rate of 15%, so we'll subtract 15% from that NOI. That subtracts $2,700 from our expected rental income. Further, we have to subtract operating expenses, such as repairs, maintenance, insurance, and taxes. Projections for these figures add up to $3,300 for the year, leaving us with an NOI of $12,000 with which to calculate the cap rate.
A word to the wise: estimate on the high side for operating expenses and vacancy rates, as it is errors in these areas that will ruin new rental investors.
Part II: How to Calculate Property Value with Cap Rates
By now, you've probably realized that the higher the cap rate, the better the rental investment property's return on your investment. If you know your target cap rate, based on personal investing goals and local market cap rates, you can calculate your maximum purchase price to make a decision on investing in a rental income property.
First, take the net rental income, and simply divide it by the target/local cap rate (in our example, .12) to arrive at an appropriate value/price. You can, of course, use the price and market cap rate to calculate the minimum net rental income required to justify the price, by simply multiplying the cap rate by the purchase price.
Cap rates are not the only useful measure of rental agreement income properties, and are often not the most appropriate. For single unit rental properties, or small multi-unit rental properties, sometimes a more precise calculation of cash flow is more useful, but cap rates remain an important concept for all rental investors to understand, and are often extremely useful in evaluating potential purchases of large multi-unit apartment buildings.
Brian Davis is both a landlord and manager of a website allowing landlords to create custom, state-specific rental agreement forms, lease addendums, eviction notices and a free rental application form.
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