Aligned Ventures
12/08/2022
In the world of real estate investing, virtually everything is about the numbers. When you buy a piece of property, you only do so after carefully examining the numbers pertaining to it. If the property has been used as a rental property in the past, you should spend time evaluating how well it has performed in the past. However, it’s also important that you look into the numbers that focus on a property’s potential earning power.
Determining a property’s cap rate is a great way to gain a better understanding of how much money a property can generate. If you’re just getting your start in real estate investing, make sure that you understand how and why to use this figure to determine a property’s potential.
How To Calculate Cap Rate
The first step in calculating cap rate is found in determining the net operating income, or NOI of the property. The NOI on a property includes the rent it generates along with any other additional fees that you can collect from the property. For instance, if you’re considering buying a 10-unit apartment complex, you should include the rent for all 10 units along with any paid parking spots, storage fees, or other amenities.
Once you have calculated how much money you can make from the property, you need to deduct the amount of money that you will need to spend on it. Operating expenses should not include mortgage payments, so even if you are leveraging funds in order to purchase an investment property, that money doesn’t count towards operating expenses. Instead, this step of the process focuses on the maintenance, repairs, taxes, insurance, and other fees. Subtract your operating expenses from the amount of money that the property should generate, and you will have your net operating income.
Once you have the amount that your potential investment property can generate in a year’s time, you will need to determine the value of the asset. While you can use certain real estate apps to get a rough estimate of the property’s value, it’s generally a better idea to consult a broker or appraiser who can give you an unofficial estimate of the property’s value.
Once you have those numbers, simply divide the net income by the asset value to determine your cap rate. For example, if your study of the numbers indicates that the property’s net operating income is $14,000 and the asset’s value is $280,000, you would perform the following equation:
14,000/280,000×100=5%
How to Use Cap Rates
One of the most important aspects of finding success in the world of real estate investing is found in doing your due diligence before you ever settle on a piece of property. Simply buying a property without evaluating the numbers is a recipe for disaster.
In most cases, a higher cap rate is a riskier investment, but it is also potentially more profitable. Developing your personal investment strategy involves evaluating how risk-averse you want to be. If you want to try to mitigate risks as much as possible, you may end up not making as much in profits, but you will also make more secure investments. Conversely, high-risk investments are often high-reward investments.
Also, knowing how to calculate cap rates can help you choose between properties when you’re faced with multiple investment options. Once you’ve determined what a good cap rate is for you (which we will discuss in a moment), you can run the same formula that we already explained for each of the properties that you’re considering. When you find the one that gives you the most favorable cap rate for your investment style, you have a better idea about which property to invest in.
What is a Good Cap Rate?
One of the most important aspects of determining a good cap rate is recognizing that you cannot just throw a blanket number out there and apply it to all properties. For instance, investment properties in one region may have a cap rate that tops out around 4%.
If you say that you’re not going to invest in anything with a cap rate lower than 7%, you will wrongly assume that none of those properties are profitable enough. Location is the most important aspect of real estate, and cap rates do vary based on a property’s location. For example, if you look at investment properties in San Francisco, you won’t find a cap rate of 10% no matter how much time you spend looking. No one would say that the Bay Area isn’t a great investment area, but the local market dictates property values.
Some investors refuse to invest in any property with a cap rate lower than 8%. These properties, while profitable, also come with a lot of risk. Most investors who want to generate a respectable return on investment without getting too risky with their money will look for a property that has a cap rate of somewhere between 4% and 6%.
A “good” cap rate for you is largely contingent on the area in which you want to invest and your own willingness to take risks.
No two investments are the same. In the same manner, no two investors are the same. When you’re evaluating a property’s cap rate, you will do with your own investment goals and strategies in mind. Spending some time researching the cap rates on other properties in the area in which you are considering investing can help you decide if a given area is the right choice for you. Once you’ve picked an area, you can use the cap rate formula to find a property that will allow you to make money while applying your own risk-mitigation strategy. Good luck in your investing goals.
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