What Is A Cap Rate?

What is a cap rate in real estate investing?
Determining the cap rate of an investment property is an important aspect of your investment.

The demand for rental housing throughout South Florida has remained strong for the past several years and this is expected to continue as more Americans look to relocate to The Sunshine State. With this said, high home prices combined with rising mortgage interest rates are also forcing many would-be home buyers to re-enter or remain in the rental market. Consequently, this may be a good time to either begin investing in income producing properties or add to your existing real estate investment portfolio. Of course, when doing so, you will want to analyze various elements of your potential investment. A part of this analysis is typically determining the capitalization rate, which is commonly referred to as the “cap rate”.

What is a cap rate?

By definition, a cap rate is the rate of return on a real estate investment property based on the income that the property is expected to generate. The basic formula for a cap rate is:

Cap Rate = (Net Operating Income)/(Current Fair Housing Market Value)

Here is the breakdown of what these mean:

Net operating income: Your net operating income is your gross rental income (the total amount of money you receive from rent) minus your operating expenses (such as property taxes, insurance, and maintenance costs). To determine this number, do the following:

  • Step 1. Calculate gross rental income: Determine the gross annual rent that you will receive from the property. For example, if a property is currently rented for $4,000/month, you would multiply $4,000 x 12. This would result in a gross rental income of $48,000.
  • Step 2. Estimate operating expenses: Estimate the annual costs associated with the property that you will be paying. Some examples of these expenses could be property taxes, insurance, repairs, remodels, landscaping, pool maintenance, & any utilities that may be included as part of the rent. For this example, let’s assume that these operating expenses amount to $8,000/year.
  • Step 3. Deduct your operating expenses ($8,000) from your gross rental income ($48,000) to determine your net operating income. $48,000 – $8,000 = $40,000.
  • Step 4. Determine the fair market value of the property you are considering to purchase. For this value, you may either use the asking price of the property or the amount that you are willing to pay for it (if lower). For this example, let’s assume the fair market value of the property is $800,000.
  • Step 5. Perform your calculation based on the values determined above.
  • Cap rate = (Net Operating Income)/(Current Fair Housing Market Value): $40,000/$800,000 = .05; Therefore, the estimated cap rate for this property would be 5%.

Adjust for vacancies

The example shown above for determining the cap rate assumes a 100% occupancy rate. In other words, you will have a paying tenant in the property for 365 days of the year. Since this is highly unlikely for all years, it is important that you factor for this when determining your net operating income. Most real estate investors tend to factor in a 5% to 10% loss of rent due to vacancies into their calculations. Therefore, assuming you use a 10% factor, your formula for calculating the net operating income would be as follows:

Net operating income = [($48,000) x (.90)] – $8,000 = $35,200. (Note that a 10% reduction in occupancy results in $4,800 less net income.)

Therefore, the updated cap rate for this property assuming a 10% loss of rent would be as follows:

$35,200/$800,000 = 0.044. Subsequently, the revised estimated cap rate for the property would be 4.4%.

Summary

In closing, the cap rate can be an important tool for you to consider for your income-producing properties. With this said, this formula is typically not applicable to properties that you are looking to flip or rent out as short-term vacation homes. The cap rate approach should generally be used for a standard rental property that you will lease out on an annual basis. Most real estate investors tend to look for cap rates between 4% – 10%. Of course, a higher cap rate is always acceptable as well. As a rule of thumb, if the property is located in an area of high demand, most investors will be willing to take a lower cap rate such as 4%. On the flip side, if the area tends to have a lower demand, it is best to hold out for a higher cap rate.

Are you thinking about investing in real estate? The South Florida rental market is on fire and this could be a good time to start or add to your real estate investment portfolio. We can help! Contact Natasha at Live South Florida Realty, Inc. today! For the most up-to-date MLS data right on your mobile device, download our free Florida Home Search App today!

By natasha moore

REALTOR® with Live South Florida Realty, Inc.

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