By Brian Davis
You own a few single-family rental properties, and you are ready to invest in a larger apartment building – how do you compare potential investments, to determine the ratio of profit-to-expenses? By using capitalization rates (also known as cap rates), of course. If that sounds complicated, fear not, they are actually quite simple to calculate, and to use to compare multiple investment properties to one another.
How to Calculate Cap Rates
The math involved is not exactly rocket science:
Annual Net Rental Income
Cap Rate = ---------------------------------------------
The key word, however, is net rental income. That means that some judgment is required, to estimate the annual costs associated with managing the property. The following annual costs need to be estimated:
• vacancy rate
• property insurance
• property taxes
• property management fees (if applicable)
Some costs are not included however, including mortgage costs, income taxes from rental income, and major property improvements (e.g. a new furnace for the building).
By way of example, if a property’s total rental income each month is $2,000, the annual gross rental income is $24,000. Say the vacancy rate is estimated at 15%, that subtracts $3,600, and say the estimated annual maintenance/repair costs are $1,500. Taxes and insurance account for another $1,500 annually, and advertising costs and supplies average $100 annually (for this example we will assume the landlord is managing the property and will not incur management costs). Thus, the total annual expenses come to $6,700, which makes the annual net rental income $17,300 ($24,000 - $6,700 = $17,300).
Let us assume a purchase price of $155,000, which makes the cap rate 11.2% ($17,300 / $155,000 = .112, or 11.2%). Note that capitalization rates are expressed as percentages.
How to Calculate Property Values, Using Cap Rates
Many investors will only buy investment properties above a certain cap rate. Say the maximum cap rate you will accept is 10%, you can reverse the formula above to determine the maximum purchase price you are willing to pay. Sticking with the example above, if the annual net rental income is $17,300, you can divide that by the .10 cap rate to calculate the maximum price – $173,000 – that you are willing to pay for the property.
Similarly, if you know the seller’s rock-bottom price, and you have a minimum cap rate you will consider, you can calculate the minimum annual net rental income the property would have to offer, to make it viable. If the seller’s final offer is $155,000, and your minimum cap rate is 10%, then multiply .10 by $155,000 to reach $15,500 – the minimum annual net rental income necessary to make the deal worthwhile.
Capitalization rates are not the only measure that investors use to evaluate rental properties; some prefer calculating monthly cash flow, which includes the details of the specific mortgage costs for the property. But there are several advantages to using cap rates to compare properties, including standardization by using a common measuring stick to measure all rental investment properties. Further, it forces you to calculate in all of the average annual costs that are so often forgotten by excited investors calculating monthly cash flow too simply. Keep capitalization rates in mind the next time you look at a potential rental investment, and take thirty seconds to calculate the cap rate – you will find it adds surprisingly to the professionalism of your investing strategy.