How to understand CAP and ROI rates means the difference between turning a profit and losing money on your rental investments.
No matter the different types of rental properties or the different real estate markets or differing economic conditions, figuring out the CAP and ROI rates before investing can make or break you.
What Is a CAP Rate?
Simply put, the “Capacity” or “Capitalization” (Cap Rate) measures the ability of a property to recoup its initial investment and provide profits thereafter.
Investopedia defines a CAP Rate as the Rate of Return on a rental investment property based on its income. This calculates the potential return on the investment.
Knowing how many years it takes to recover your total initial investment becomes very important in determining the value of the investment. If you intend to sell the property within 10 years, the CAP rate helps you to see the feasibility of that goal.
In essence, the CAP rate measures the Net Operating Income (NOI) of your investment. It estimates the cash flow income. While it’s easier for a CAP rate to determine the NOI on an all-cash investment, the total financing costs can be determined on your Return on Investment (ROI) explained below.
What Types of Properties Will a CAP Rate Help?
Estimating and comparing the profitability of rental investment properties makes no difference whether they are single-family homes, duplexes, triplexes, apartment buildings, or luxury high-rise condos.
In essence, the CAP rate provides investors with a simple formula for estimating profitability before buying.
Making the CAP Rate Calculation
Learn how to analyze rental investments. If you don’t do the math before investing, you’ll never earn the profits you seek.
No one correctly predicts the future. However, with solid analysis, you reduce the risks in any investment. Poor math creates poor investments.
Savvy rental investors learn how to calculate risk vs. rewards.
Basic Capitalization Rate
Many investors preview potential rental investment properties around the same time and perform a basic CAP rate analysis. The basic CAP works best when comparing different properties to determine which ones to pursue.
CAP Rate calculated by dividing the rental’s Net Operating Income (NOI) by its present market value or recent purchase costs. The formula looks like this:
Example of a CAP Rate Calculation
You wish to purchase a rental for $1 million and expect to generate $120,000 per year after operating costs. The CAP Rate is $120,000 divided by $1 million = 0.12 converts to 12%.
Now use this 12% CAP Rate to compare other similarly priced rental investments to decide if they are good investments.
Advanced CAP Rate
While the basic CAP rate calculation works best when comparing potential rental investments, the advanced one calculates more important data.
Follow these 4 steps in order to make an advanced CAP rate calculation:
- Calculate the gross annual income. Even though you don’t own the property yet, you must research the local rental rates.
- Next, subtracting 10% of the total annual rental income accounts for potential vacancies.
- Net income determined by subtracting all costs with operating the rental. These include taxes, insurance, utilities, management costs, maintenance, and other costs.
- Now, divide the net operating income by the total acquisition costs. Include the closing costs, brokerage commissions, and all rehab costs when making it “rental ready”. The result amounts to the CAP rate as a percentage.
However, this calculation does not include financing costs. When financing, you must include the yearly financing costs as an operating expense.
Now, you see the relationship between rents, acquisition costs, and operating costs. If your acquisition costs were higher than comparable rentals in your market, you must increase the rent to achieve the desirable CAP rate. Failure to obtain higher rents to overcome higher acquisition costs results in a shrinking CAP rate.
Ideally, you want to purchase and renovate a rental for less than local comparable rentals. Then, rent out at the going rate to raise your CAP rate showing a greater return on your investment. This makes short sales and foreclosures a “boom” for “buying and holding” along with “fix & flip” properties.
Why CAP Rate is Important
Calculating rental CAP rates shows the importance of controlling operating costs. Subtract operating costs from the rental income to show net income. Lowering operating costs raises the CAP rate resulting in higher profits.
Make sure all operating costs included in your CAP rate calculations. Always estimate vacancies. Never compare single-family home rentals with apartment CAP rates. They are completely different types of rentals incurring differing costs and rental rates.
Remember, most online CAP rate calculators assume all cash purchases.
What is a Good CAP Rate for Rentals?
Most investors consider an ideal CAP rate to be at least 10%.
The Shortfall of CAP Rates
While a CAP rate serves as a simple calculation to help investors shopping for rental properties, they are not the final word.
First, CAP rates don’t take into account appreciation, an important factor for determining the return on investment.
Second, CAP rates do not take into account risks and real-world opportunities. For instance, knowing of an upcoming market growth makes sense to invest now and tough it out until higher rents occur when the economy improves.
Return On Investment (ROI)
The Return on Investment (ROI) calculation for rental investments must follow an initial CAP rate calculation.
Investopedia defines ROI as the ability to evaluate an investment’s efficiency based upon performance. Simply put, efficient performance forecasts profitability.
Calculate ROI by comparing the Annual Investment Gain minus the Annual Investment Costs divided by the Investment’s Total Cost. This results in a ratio or a percentage. This is how an ROI formula looks:
Annual Investment Gain: Take the actual cash flow from rental income plus other sources like laundry mat, vending machines, cable TV/internet hookup, etc.
Annual Investment Costs: Add up the annual repairs, maintenance, insurance, property tax, and costs of finding tenants, etc.
Total Investment Costs: Rental investments require calculations of different variables determining Total Investment Costs. These include purchase price, loans, interest, brokers’ commissions, appraisal costs, and other closing costs when purchasing and selling.
Example ROI
An example of ROI looks like this:
Annual Investment Gain: Let’s say your average rentals bring in $2,500 per month. Multiply by 12 months = $30,000 per year.
Annual Investment Costs: Add up the annual expenses like insurance, taxes, maintenance, repairs, etc. Let’s say they amount to $2,000 per year.
Subtract Investment Costs from Investment Gain: $30,000 – $2,000 = $28,000.
Divide this number by Total Investment Costs: Let’s say you bought the rental unit for $280,000. The division shows $28,000 ÷ $280,000 = 0.10
Convert the decimal to a percent: This gives you 10% meaning you can expect to receive 10% Return on Investment (ROI) every year.
What’s a good ROI?
According to Balance, which writes about personal finance since 1998, in 2018 U.S. real estate ROI “stabilized at 10%”.
Therefore, the example above provides a good ROI for 2018 at 10%.
Conclusion
How to understand CAP and ROI rates helps rental investors to determine if a property is worth purchasing.
CAP rates only provide a basic rule of thumb calculation to help rental investors compare properties in deciding which ones to pursue.
ROI Rates measure a rental investment’s efficiency by predicting its performance to forecast profitability.
Both the CAP and ROI rates should be at least 10%.
Before buying rental properties make sure to calculate property management costs and benefits to save you time and money from self-managing your rentals.
Contact Us to learn how we help rental investors to manage their properties with expertise and efficiency.
Steven Rich, MBA – Guest Blogger
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