The following article Calculating Cap Rate is courtesy of This Great House Blog
The start of the new year 2016 has been the roughest one on record for the stock market. Huge losses and investors are in a full panic. So where do you put your money that it will be safe and constantly give you good returns? Investment property or rental properties! It is a great way to build long term wealth as well as collect rent every month where someone is actually paying the note for you and hopefully if you did your calculations right, you make a nice spread. But how do you make sure before you purchase an investment property that you will make money on it? The answer is - "cap rate". 
There is more to buying a rental property for an investment than just looking at the purchase price, how much the note is and how much you can rent it for. The savvy real estate investor takes a few other factors into consideration before pulling the trigger. The math involved isn't that hard, but we have seen in the past newer investors skip this step and not make money like they should and be disappointed on dismal returns on their investment properties. So what is cap rate and how do you calculate it? It really is quite simple. Cap rate is the measurement of how much a property produces compared to how much it costs. I actually came across a great article that explains it probably better than I can from BiggerPockets.com written by Che Chiu Wong. Here is a little from the article -
Buying cash flow properties is one of the greatest ways to build wealth. To do this right, you have to buy smart. Run your numbers, that’s what we say. But how do I exactly do that? This is what we are going to explore. A good way to do this is to determine the Capitalization Rate of the property (Cap Rate in short). Capitalization Rate is a crucial indicator for real estate investing because it measures the rate of return on your investment, i.e. how much you get for your money’s worth. However, surprisingly, this concept is often misunderstood within the investment circle. If you ask 10 people what the Cap Rate is for a particular property, nine out of the 10 people will give you a different answer. The last one will ask, “What is cap rate again?” Jokes aside, the aim of this article is to clearly define what Cap Rate is all about, how and when you will use Cap Rate to analyze your deal, and why different people calculate Cap Rates differently. Learning to calculate and understand Cap Rate is a powerful tool for your real estate investing career.Read The Full Article Here So that will give you a good explanation of how Cap Rate works. Brett Lee goes on to explain more on how to calculate more for calculating the cap rate -What is Cap Rate?
In plain English, Cap Rate can be described as such: If you purchase an investment property ALL IN CASH, for each $100 you put in, how much is your profit per year after you have paid your expenses? The keywords are: “cash,” “profit per year,” and “after expenses.” CASH: It assumes cash, i.e. we don’t consider how a mortgage may change our return. PROFIT PER YEAR: It assumes there is regular income generated from this property. AFTER EXPENSES: It assumes there are expenses being associated with this property. Often, Cap Rate is represented in percentages. For example, instead of saying Property A’s Cap Rate is $7.50 per $100 invested, we will just say Cap Rate is 7.5%. It means the same thingHow is Cap Rate Used?
Cap Rate is mostly used to compare income-producing properties. It gives a unified gauge for you to compare, even if the properties are somewhat different. For example,Scenario 1
Property A: 2 units, rent = $2000/mo, selling for $250,000 Property B: 3 units, rent = $2500/mo, selling for $300,000 It is quite difficult to determine which one is a better deal. Looking from a purchase price per unit standpoint, Property B seems cheaper ($100,000 vs. $125,000), whereas looking from a rent per purchase price standpoint, Property A looks better (8 per thousand vs. 7.667 per thousand). We don’t know what the associated expenses are for each property, further clouding our judgment.
So there you have it. It's a lot of reading, but once you get a grasp on it, it's not that hard to do and very useful information on helping you decide on whether or not. If you still aren't sure how to do it, join a REIA and attend some meetings and ask some other investors that have been around awhile. You can also do more searches on the internet and find all kinds of information about the subject.Most investing decisions come down to math. Property evaluation is too complex without it. If you really understand the benefits and limitations of the most common investment equations, you’ll make better decisions, reduce your work load and be able to act quickly.
The best way to look at a cap rate is as a return on the value of a property. A 10% cap rate will give you 10% return on the value of the property over a single year after costs have been deducted.
How Cap Rates Work
For many investors, cap rates are the magic bullet. It’s the first thing they turn to when making decisions because it takes into account costs and income. While cap rates do give you a lot of information and help you compare properties, they also leave out a lot of information. Let’s get to the math so we can better understand how it works and how to avoid common mistakes.
Cap Rate = Net Operating Income/Value
NOI is the gross yearly income from a property minus the expenses (does not including mortgage payments, income taxes or depreciation).
Gross income:
Total of all rents and other income the property produces in a yearCosts include:
Vacancy loss (how much rent will you lose in an average year due to vacancies) Routine maintenance (yard work, painting, etc.) Property management fees Property taxes Advertising Utilities that you pay forExample
- Property is valued at $250,000
- Rental income = $18,000 a year
- Vacancy loss averages 2% for your area = $18,000*.02 = $360 a year
- All expected maintenance = $1,200 a year
- No property manager, advertising or utility bills for this property
- Property taxes = $3,000 a year
- Cap rate = ($18,000 – $360 – $1,200 – $3,000)/$250,000 = 0.054 or 5.4% cap rate
How to Interpret Your Cap Rate
Cap rates are different everywhere you go. Because value (price) is part of the equation, cap rates are based on supply and demand in your local area. In the U.S. most real estate falls in the 5%-10% range. It is possible to do better, but it usually requires creative thinking.
Cap rates have three important uses.
Continue Reading The Article Here
- The cap rate can help you understand if a property is priced too high or low for an area. All you have to do is compare the cap rate from the property you are looking at to the average cap rate for the area. An above average cap rate for an area can be an indication of problems with the property.
- If you decide you won’t do a deal unless you get a certain cap rate, then you can use it to decide what price to offer.
- If you know the average NOI (cash flow) for this deal is going to be $30,000 a year and you will only do a deal with a cap rate of 8% or higher, then you should bid $30,000/.08 = $375,000 or less.
- If you know what cap rates are common in the area and and you know the asking price, you can get an idea of the Net Operating Expenses assuming cap rates were used to price the property.
- If the average cap rate in the area is 6% and the asking price is $300,000, then 0.06*$300,000 = $18,000 in expenses for the year.
