How to Determine Your Target Cap Rate
Most seasoned real estate investors will be looking to achieve a minimum capitalization rate (cap rate) on any rental property that they purchase. In this article, we will be digging deeper into what a cap rate is, along with the factors that you need to consider when determining your ideal cap rate and running the calculations for each house you look at.
What is a Cap Rate?
In the simplest of terms, a capitalization rate is an indicator that investors will use to help determine their rate of return—or ROI (return on investment) if you prefer. It is measured by forecasting the realistic net income potential of the property for any given year. It is calculated by dividing the net operating income by the property asset value. In the end, you will have a percentage that you can use to compare one investment property to another.
Most experienced investors and cash home buyers will have a target cap rate in mind. It may be a modest percentage or it could be more aggressive. Most buyers in the PropertyLark network are targeting anywhere from 4-12% cap rates. Your target may depend on your market(s), your budget, your experience and your overall income goals. Some investors may want fewer properties with higher cap rates while others will buy more properties with lower cap rates and make their money through a larger investment portfolio.
Pros and Cons of Cap Rates
Ultimately, a cap rate is helpful when you want to quickly compare two properties. It allows you to look at relative values and rates of return side-by-side. If you are looking at multiple properties in the same market or of similar cost, you can run the cap rates on both and determine which is the smarter investment.
Though cap rates can be useful for quick analysis, they should never be your sole indicator of a real estate investment’s strength. After all, they these calculations typically won’t take every single factor into account. Inflation or deflation, equity growth or loss, future cash flows and time are among the things that you can’t always predict exactly and aren’t really part of the rather basic cap rate equation:
Capitalization Rate = Net Operating Income (NOI) / Current Market Value
Net Operating Income
This is the annual income you expect to generate from the rental property. The NOI will take some calculating of its own. You take your anticipated rent income and then deduct the costs it will take to own and manage the property for the year (property taxes, upkeep, property management fees, etc.).
Current Market Value
The current market value is pretty simple. It is the present-day value of the property based on current market rates.
Current Value vs. Purchase Price
Some investment experts will say that you can replace current market value with your actual purchase price. This may work at the very beginning of the purchase when comparing two properties you are thinking about buying. However, cap rates should be run annually (as long as you own the property) to account for higher operating costs, property appreciation, rent increases and other factors. You may find what was a good investment in its first year is not a great investment in its fifth year, and it may be time to move on. Even better, you may see the cap rate going up year after year on your best investments.
Obviously, there are a lot of variables that can go into calculating capitalization rates and comparing one rental property to another. Running these numbers is a great way to compare investments, but it should never be your only decision-making tool. A lot more goes into making a major investment decision and deciding which properties are best to buy.
The PropertyLark Analytics Advantage
One advantage of the PropertyLark home buying network is that we have custom software and experienced investors on our team that calculate cap rates and analyze many different factors. This is how we identify excellent investment properties that we pass onto our qualified buyers. To learn more about our process or to apply to become a PropertyLark buying network member, contact us today.