What Is a Cap Rate on a Rental Property? Everything You Need to Know
If you’re self-employed, such as a real estate investor, you need to make sure that you’re generating a solid return on your investment. There are several important metrics you need to follow, such as your occupancy rate and your total monthly revenue, but you might also be wondering, “What is the cap rate on rental property?”
Cap rate is short for capitalization rate, and anyone who invests in real estate has to keep a close eye on this metric. It’s the ratio of the net operating income from the property to its current market value and is used to evaluate the potential return on an investment property.
Understanding how to track and calculate a capitalization rate is a crucial part of managing an investment property.
- The cap rate is a crucial metric that all real estate investors should track to help determine the profitability of a rental property.
- If a property has a higher capitalization rate, it could be a better investment, but it might also come with some greater risks.
- There are a number of factors that can influence the capitalization rate of a property, such as its condition, location, and overall market trends.
What Is a Cap Rate on a Rental Property?
Cap rate is a metric that allows real estate investors to calculate the potential return on a rental property based on the amount of income it generates.
The income the property generates is a crucial part of its value, and the income of the property should be taken into account alongside its potential market value.
If you want to calculate the capitalization rate on a rental property, you need to figure out its net operating income and divide it by a potential value. The value of a property is the amount of money it could sell for if it goes to the open market.
If you want to build a cash-flow-positive real estate portfolio, you must make sure you have a solid understanding of what a good cap rate is.
It’s important to note that you should not view the capitalization rate of a potential rental property in isolation, as there are other factors that could make a property a good or bad investment.
Should You Look for a High or Low Cap Rate?
So, what is a cap rate on a rental property, and should you look for properties with a high or low cap rate? Ultimately, as you are trying to navigate real estate investing in the current market, you need to think about your risk tolerance, goals, and investment strategy.
For example, if you are considering rental properties that have a high cap rate, it means that there is a higher ceiling on that potential investment. It could generate significantly more income relative to its value, but properties that have this type of upside are typically located in areas with lower incomes, as their property values tend to be lower.
On the other hand, if you are targeting properties with a low cap rate, it means that there is a significantly lower potential return on that investment. In contrast, these properties may have lower risk profiles, as many of these properties have higher values, meaning that they are in more desirable areas.
You might have access to a more stable cash flow, but because the properties already have higher values, some of your overhead expenses may be larger. Therefore, you need to consider the cap rate of a potential property next to your financial goals and investment strategy.
The Cap Rate Formula
As you try to answer the question, “What is the cap rate on a rental property?” you need to have an understanding of the formula. It is as follows:
Cap Rate = Net Operating Income (NOI) / Rental Property Value
To complete this calculation, there are a few steps you need to follow:
- Calculate Your Net Operating Income (NOI): This is the total amount of income you generate from the rental property after subtracting your operating expenses. To calculate NOI, you need to subtract your overhead expenses from your total income. Some of the most common examples of overhead expenses include taxes, insurance, management fees, maintenance costs, utilities, repairs, vacancy rate, and HOA fees.
- Determine the Current Market Value: The current market value of your property is the amount of money someone would have to pay for it to take it off your hands. There are different ways to calculate your current market value, but there are some tools that can help you estimate the value of your property online by comparing it to similar properties that have sold in your area recently.
- Complete the Division: Finally, you need to take your net operating income and divide it by the value of your property to calculate the cap rate.
You probably tracked the income you generate and the value of your property over time, so you may want to keep an eye on your cap rate as well.
What Is a Good Cap Rate on a Rental Property?
You might be wondering, what is a good cap rate on a rental property? There are many people who aim for a cap rate of 10 percent, but some people might be wondering, what is an acceptable cap rate on rental property? If you have a cap rate of 5 percent, this is generally considered acceptable.
If you have a cap rate under 5 percent, it could indicate that you own property in an area that is already very desirable or is appreciating in value quickly. This could also indicate that people who have rental properties in this area are willing to accept a lower return and exchange for greater property value appreciation.
If you have a cap rate of 10 percent or more, it could indicate that the property is in a less desirable neighborhood with more risk, but it could also increase in value more quickly if the area develops.
Remember that just because you have a high cap rate doesn’t necessarily mean that you will have a successful investment. Market trends, the condition of your property, rent or demand, and the location of the property itself contribute to the overall value of your investment property.
Comparing Cap Rates
When trying to determine “What is an acceptable cap rate on a rental property?” you need to consider it in the appropriate context. Remember that the location of your property and overall market conditions could have an impact on the value of the property itself. That’s why you must take a closer look at the factors that will influence current cap rates.
Factors That Influence Current Cap Rates
Some of the factors that will influence current cap rates are:
- Market Conditions: The supply and demand of the local real estate market will have an impact on your cap rate.
- Economic Factors: Interest rates, job growth, and inflation rates can all influence cap rate.
- Property Quality: The condition of the property and how well it’s been taken care of could negatively impact the overall cap rate.
- Location: If the property is in a location with strong property value appreciation, it could reduce the cap rate.
As you calculate cap rate, be sure to take these factors into account and make an informed decision.
What Other Metrics Should You Use When Evaluating an Investment Property?
Just as there are many factors to consider when you’re looking for investor property loans, you need to consider other metrics when you are looking for an investment property. Some of the other factors you may want to consider include:
- Appreciation Rate: You should figure out how quickly the properties in the area are going up in value.
- Cash on Cash Return: This compares the annual pre-tax flow generated by the rental property to the total cash investment you made in it.
- Debt Service Coverage Ratio (DSCR): DSCR will let you know if the gross rental income will cover your full mortgage payment.
- Gross Rent Multiplier: GRM will help you determine how competitive the property’s rent is. You can calculate this metric by dividing the purchase price of the property by its annual gross rental income.
By taking all of these metrics into account, you can make an informed decision about which property is the best investment based on your priorities.
Apply for a Real Estate Investment Loan
If you’re looking for a real estate investment loan, be sure to consider all the options that are available to you so you can make the most of this new opportunity.
Griffin Funding offers conventional and non-QM loans like DSCR investor mortgages to help you find a loan solution that caters to your circumstances. We can recommend the best loan options based on your circumstances–for example, helping you compare a DSCR vs. a conventional loan.
Whether you’re looking for San Diego real estate investing opportunities or properties in up-and-coming markets, we have the experience and expertise to help you secure a loan with confidence. Apply online or call us at 855-698-1098 today to get started.
Frequently Asked Questions
What is the cap rate 2% rule?
What are the disadvantages of using cap rate to evaluate a property?
What makes cap rates go down?
What is the difference between cap rate and return on investment?
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