July 19th, 2016 5:04 AM by Jackie A. Graves
If you’re thinking of investing
in real estate by
buying a home and renting it out, there’s just one term you’ll need to
know above all else: “cap rate.” So what is it?
rate, or capitalization rate, is the ratio of a property’s net income to its
purchase price. It’s an essential number for gauging a property’s rental income
potential. Many newbie real estate investors, for instance, assume that as
long as their renters are paying more than their mortgage on the property,
they’re golden. But that’s not the case. You also have to factor in your
investment dollars, taxes, and other variables. That’s what cap rate does
in one fell swoop.
rate is both a measure that tells you how much you are earning on the
investment and a proxy for determining the risk of an investment,”
says Bruce Ailon, a Realtor® and attorney
in Alpharetta, GA.
your calculators handy, guys: Determining the cap rate will involve a bit
of math. We break it down into bite-size pieces:
property is currently leased, these numbers will be easily
available. If you’re hoping to turn an owner-occupied home into a rental, look
at rental listings on Craigslist or realtor.com® to see
rents for similar properties in the same neighborhood.
say you’re buying a two-family townhouse and can lease each side for
$1,000 a month, or $12,000 per unit per year. That means that every
year, at full occupancy, you can expect to receive $24,000 in gross
Rental homes require
maintenance, management, insurance, and utilities. There’s also the cost of
vacancy, estimated at around 7% and
representing the amount of time your unit is unoccupied and not producing
income. (It’s important to note that your mortgage payments and other
purchasing costs are not included in these expenses.)
the property’s yearly expenses and subtract this sum from your rental
income. For our two-family townhouse, you might pay $500 for property
management, $650 for taxes, $400 in maintenance, $300 in insurance, and $1,680
in vacancy losses. That adds up to $3,530. Subtract that from $24,000 and
you’ve got a net income of $20,470.
take your net income and divide it by the property’s purchase price. So
if we purchased the two-family townhouse for $250,000, we’d
divide $20,470 by $250,000. The result: 0.081. This translates to a cap
rate of 8.1%, which is the expected annual return on your investment.
As one might expect, the higher the cap rate, the better. For
most investors, 4% is the bare minimum they’ll consider for a rental
property. Any less, and an unforeseen circumstance (e.g., a long period
without tenants or an HVAC problem that leaves the home uninhabitable for six
months) could quickly put you in the red.
different cap rates in the neighborhood
where you would like to invest is
an excellent way to determine which properties will make you a nifty
profit, or not so much. If another duplex had a cap rate of 9.8%, it
would probably be a better deal.
you might think a high cap rate is a great indicator of success, Ailon has some
caveats for properties with cap rates greater than 12%.
is a greater risk of not getting the return you expect, and perhaps not
getting your investment back,” he says. So try to stick within that 4% to 12%
cap rate window if you want to play it safe, and when in doubt, be sure to
consult your Realtor with any questions.
By Jamie Wiebe - To view the original article click here