Cap rate is one of the most important metrics you can use when investing in the rental sector. If you’re already involved in or you’re doing your research before diving into the rental property world you’ve likely heard of it already.

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The truth is that cap rate is incredibly important, but shouldn't be viewed in isolation. The more contributing pieces of data and information you have access to, the more likely you are to have a clear picture of your investment.

What Is a Cap Rate?

Cap rate, otherwise known as capitalization rate, is a metric used to understand and measure the expected return that a rental property will yield over a certain period of time. You can use the metric to gauge, roughly, how profitable a property will be and if, for example, buying that vacation property is a good investment or not. The issue is that it doesn’t take into account a wide number of other factors that can affect the percentage rate. We’ll explore those factors and some of the limitations that cap rate has later in this article.

Calculating Cap Rates: Capitalization Rate Formula

It’s a relatively simple metric to calculate, simply take the total net income that the property generates over a given period (or the expected net income) and divide it by the total asset value. That answer can then be expressed as a percentage.

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An example:

• A vacation property has a value of $650,000
• It can be rented out for $3,600 a month
• That means an annual rental income of $43,200
• $43,200 / $650,000 = 0.066
• Multiply by 100 to express as a percentage = 6.6%

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This is the basic version of cap rate calculation. A more useful method is to use operating income rather than net income. To calculate operating income you simply take the net income and subtract any operating costs such as management fees, repairs, and maintenance.

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To go one step further, you should also only base the income rate based on the average occupancy rate. It is unlikely that your property will be booked 100% of the time, instead you should work on an average occupancy rate. These vary from place to place, and a local agent should be able to give you a clearer indication. If you don’t have access to an agent, we would suggest working on an occupancy rate of around 70%.

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What Is a Good Cap Rate for a Rental Property?

The higher the percentage, the better the yield. The above example would be a fairly average property to invest in. A good vacation property rental yield is typically in the 8-12% range. This varies massively from state to state, in Hawaii the average rental income is $73,247 whereas in Alabama it is considerably lower at $41,937. It stands to reason that the more expensive the property prices are, the more likely it is that the rental income will be higher.

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There is no fixed “good” cap rate, rather you need to consider what is good for that area. Rather than comparing your cap rate against others, consider if this is going to be a good return for you. Using the above, simplistic example, it would take you just over 15 years to get back the money that you put into the property (assuming you invested the full $650,000). Consider if this is an investment that you’d be interested in working with.

Why Is the Cap Rate Important for Evaluating a Rental Property?

There are several different scenarios when cap rate becomes an important factor. Typically, it is used by investors as a guide to the eye when scanning for properties. If a cap rate is deemed too low then they won’t even consider viewing the property, a higher cap rate makes for an attractive proposition. Some investors will also use attractive historical cap rates to entice buyers when they come to sell an investment property.

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Cap rate is only used in situations where the property generates income, therefore the metric isn’t used in traditional home purchasing. It would, however, be used when purchasing:

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• Properties that can accommodate multiple family units
• Whole apartment buildings
• Vacation properties
• Single family rentals
• Commercial or industrial real estate.

Factors That Affect Cap Rates

Cap rate is influenced by factors beyond the purchase price (or market value) of the property and its rental income. The following factors influence the rate too:

Income and Expenses

Once you start renting out the property there’ll be income, after all, that’s the whole point of doing this. There will, however, be expenses. It is highly unlikely that you’ll get through a year of renting out a property without incurring some sort of expense, even if it is simply the managing agent’s fees.

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You can predict some costs such as cleaning fees and energy bills, but you should go one step forward and create a rental income sheet known as a rental pro forma that helps you also predict occupancy rates, factor in larger maintenance costs, and more.

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You should base your calculations on a scenario in which the property is rented at market rate on an expected occupancy basis. You can, of course, predict better or worse scenarios. Using the average will give you the most likely outcome.

Timing

The property market is a relatively stable and predictable beast, but it isn’t without its nuances and fluctuations. At a time when the property sales market is buoyant, cap rates tend to drop as purchase prices are higher. When sales decrease, and therefore sellers reduce their prices, the cap rate increases.

Location

As in all things to do with property, location is a huge factor. A beachfront property with a high listing price will have a low cap rate but is likely a better investment for a vacation property. Whereas an urban property with an average listing price could potentially yield a higher cap rate.

Key Takeaways

Cap rate is a great metric to start your considerations and act as a guide, but you certainly shouldn’t go for an investment based exclusively on a cap rate figure. Consider the myriad factors above and take a more holistic view of the investment. Do this, and you’ll find yourself with a positive, profitable investment.

• Remember that what might be considered a good cap rate in one location will be worse or better in another.
• Local agents or experts in the rental market will be able to give you a clearer indication of investment opportunities.

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