Part One: Cap Rate // How to Calculate the Return on Investment of a Rental Property
Owning investment real estate is a powerful and effective way to build wealth.
But, is it the best way every time?
How do you know if a potential investment property will make a good rental or if you should keep your home as a rental when you move you?
Maybe you should sell and invest the profits in the stock market.
If your home is paid off, that means it HAS to be a great rental, right?
Right?
Maybe. Maybe not.
The answer lies in the numbers.
I wrote this three part series to help the new investor learn the basics of calculating the potential return on investment of a rental property.
This article is Part One.
Check out parts two and three of this series here:
Part Two: Cash-on-Cash Return - helpful if you have a mortgage on a rental property
Part Three: Return on Equity - helpful as your rental property value changes or if your mortgage gets paid down (or paid off)
Note: This article focuses on basic cash flow calculations and does NOT take into account your individual potential tax implications. Please consult with a CPA prior to making any decisions.
Cap Rate
A cap rate provides an anticipated rate of return on the cash purchase of an investment property.
Investors commonly use this calculation like “I’m looking to buy a 6 cap.” This means they want to earn an 6% return on their money.
The math would look something like this:
Annual Income - Annual Expenses (aka Annual Net Profit) / Purchase Price = Cap Rate
Purchase Price: $300,000
Annual Income: $2,000 rent per month * 12 = $24,000
Annual Expenses: $500/mo (taxes, insurance, maintenance/utilities + $100 reserves = $600 per month * 12 = $7,200
Annual Net Profit: $24,000 - $7,200 = $16,800
Cap Rate Calculation: $16,800 / $300,000
Cap Rate: 5.6%
The primary way to IMPROVE a cap rate is to INCREASE the gap between the Income and EXPENSES.
This is most simply done by ensuring that annual rent increases are greater than increases in annual expense.
What is a good cap rate?
A “good” cap rate varies depending on location and market conditions and type of property, but in my experience most real estate investors want a 6-7% rap rate - or higher is always good :).
In a housing market with high home prices and high interest rates, it’s not uncommon for homes to be marketed with a projected cap rate instead of the present cap rate, because in as-is condition, a buyer wouldn’t make any money.
An investor’s job is to see if a property with a 0% cap right now (break even, no profit) might be able to produce a 5-6% return with appropriate property improvements and rental rate increases.
What are your options?
If you do the math and believe a rental property will be a worthwhile investment, feel free to reach out to me if you’d like a “second set of eyeballs” on your situation.
If you’re considering selling instead of renting, or have a rental home that no longer makes financial sense, please reach out to me for a confidential selling consultation.
There might be important tax deadlines to consider or creative options such as a 1031 Exchange that allow you to stay involved in owning investment real estate that will provide you a greater ROI.
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This article is Part One.
Check out parts two and three of this series here:
Part Two: Cash-on-Cash Return - helpful if you have a mortgage on a rental property
Part Three: Return on Equity - helpful as your rental property value changes or if your mortgage gets paid down (or paid off)
If you have a desire to buy or sell in the coming year, let’s chat.
Life has a way of keeping us all moving, and I’d love to be your real estate agent.
Contact me here to set up your free and confidential consultation.
Kevin
