In real estate – particularly in real estate investing – you’ll hear a lot of terms that most people don’t use every day. One of those terms may be capitalization rate, or cap rate for short. So what does cap rate mean, and how does it apply to you as an investor? This guide explains.
What is a Cap Rate in Real Estate?
A property’s capitalization rate (commonly called cap rate) is a way to look at a real estate asset’s rate of return – that is, how much money it’s likely to bring in. Although a cap rate isn’t perfect, it’s a pretty simple way to calculate an asset’s value quickly and fairly accurately. You shouldn’t use a property’s cap rate as the only indicator of an investment’s strength.
Many people use a property’s cap rate to figure out how it stacks up – investment-wise, anyway – against other, similar properties. For example, if you’re looking at a couple of fourplexes for sale and one has a better cap rate than the other, you may decide that it’s a better buy for you.
How is Cap Rate Determined?
You can determine a property’s capitalization rate by dividing its net operating income by its current market value.
Net operating income is the expected annual income of a property minus its operating expenses. For example, if a fourplex charges $2,000 a month in rent for all four units, that’s a total of $8,000 per month in rental income. Multiply that by 12 to find that the property is expected to bring in $96,000 per year in income.
Then, deduct all the expenses incurred for managing the property to find its cap rate. Those expenses include:
- The mortgage payment
- Regular upkeep of the building
- Property taxes
- Maintenance, such as lawn care
- Advertising costs for vacant units
- Common incidental expenses
Let’s say that the expenses of managing the property total about $6,000 per year. Deduct that amount from the expected income: $96,000 – $6,000 = $90,000. Then, use that figure and the property’s current market value to determine its cap rate.
If the property is currently worth $1.000,000, your mathematical formula looks like this;
$90,000/$1,000,000 = 0.09
That means the property’s cap rate is 9 percent. That means it’s likely that you’ll earn a 9 percent return on your investment when expenses and property value remain the same. Remember, though, that this number will fluctuate when you factor in your actual expenses and the property’s actual worth after you make a purchase. Other factors that will impact the property’s cap rate may include:
- The property’s age, location and condition
- How other properties around yours evolve (such as when a new hospital is built across the street, the nearest school is demolished, or property values decline due to other fators)
- The type of property you have and how in-demand it is
- The terms and structures of the leases you use with your tenants
Are You Buying or Selling a Duplex, Triplex or Fourplex in Silicon Valley?
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