Cap Rate is a great tool
Calculating the cap rate on investment properties is easy once you know how and it’s a great tool for comparing seemingly similar investments.
First, find out the net operating income of the property that you’re considering. Sometimes this is provided by the seller but sometimes you have to calculate it on your own using annual income less any expenses – excluding mortgage. All cap rates are done as if you are paying cash for the property.
Let’s say that the property that you’re thinking of buying has $50,000 in rental income annually. Taxes are $5600, insurance is $2000 and owner-paid utilities average $3000 annually. We add up the expenses: $5600 + $2000 + $3000 = $10,600. Then we subtract that number from the annual income to get the Net Operating Income: $50,000 – $10,600 = $39,400.
Next, we divide the Net Operating Income by the price of the property that we’re thinking of purchasing. In this case, let’s say the property price is $492,500 so: Net Operating Income $39,400 / Purchase Price $492,500 = .08. That means this property has a Cap Rate of 8. The higher the cap rate, the better the cash flow!
In my market, Boston MA, a cap rate of 5 is considered good by most investors but in many markets, buyers expect double-digit cap rates before they’ll consider a property as a good deal. Ask a realtor or other investors in your area what average cap rates are in the market that you’re considering.
You must also factor in the risk when comparing properties. If the investment is risky, meaning that the building needs repairs, tenants don’t have leases and may leave or may not pay, there could be some type of city zoning changes coming that would impact the property, etc, the cap rate should be higher to compensate. Safe investments, for example buying a property with a long-term lease by a successful company, can have a relatively lower cap rate and still be considered a good investment.