After reading the first steps of rental property investing, you have decided to explore this investment opportunity further. The next step is to do a thorough cash flow analysis to understand the potential Capitalization Rate and Return on Investment (ROI). We have put together an easy-to-use return calculator for this specific reason. In your calculation, you will inevitably stumble upon Capitalization Rate. What is it? What is a good capitalization rate? How is it different from ROI, and why it’s so important.
What is a capitalization rate?
Capitalization rate or Cap rate is a rate of return you can expect to earn on a rental property without taking into account loan information. It is called an un-leveraged rate of return.
It is a simple calculation.
Capitalization Rate = Net Operating Income (Rental Income – Expenses) / Market Value of the Property.
Expenses are expenses related to running the rental property, such as repairs, maintenance, utilities, and other such costs. It doesn’t involve any financing-related costs like interest expense and so on.
The best use case for cap rate is to compare rental properties to see which is a better deal for you.
It is a quick and dirty calculation and is usually the first calculation you make to see if the rental property investment makes general sense.
Here is an example. You are looking at a unit that is listed on the market for $500,000. After browsing local rental listings, you see that comparable units rent for $2,000. These units are easy to maintain, and in your agreement, tenants cover all the utilities. You set aside healthy reserves every month for maintenance and repairs and estimate your monthly costs of running such a property to be approximately $300. Therefore, your Net Operating Income (NOI) for the month is $,1700 or $1,700 x 12 = $20,400 for the year.
Thus, Cap Rate on this propety = $20,400 / $500,000 * 100 = 4.08%
Comparing to other properties, everything below 4.08% will be a worse deal on paper.
Something to keep in mind, however, you also need to estimate vacancy percentage. This is the percentage of time that the property will go without rent and you without income. Many other considerations make one property better than the other, even if it has a severely lower capitalization rate.
What is a good capitalization rate?
Capitalization rates are only reasonable as quick estimates, but there are also known market-specific cap rates. These are cap rates that you should theoretically expect in your given market.
For the area with very high prices like New York, it is common to see capitalization rates range from 2.5%-5%. Property type also makes a difference, with condos typically having lower cap rates.
Although these are benchmarks, if you see cap rates that fall outside the 3%-6% range, do a more careful calculation. For example, it could be that the market you are in is experiencing high price appreciation while rents remain relatively flat. That will significantly reduce your cap rate.
Sources to consider
One great data source is NCREIF – The National Council of Real Estate Investment Fiduciaries. NCREIF produces a report every quarter that summarizes cap rates, returns, appreciation statistics and other metrics that can be useful for us as investors. These reports are not free however but can be found for free on different websites.
Use benchmark cap rate to figure out the property purchase price.
We can use cap rate benchmarks to calculate what our potential purchase price should be. This is simple to calculate
Purchase Price = Rental Income (Annual) / Desired or Benchmark Cap Rate.
For example, we know we can earn $2,000 on a property a month, and we want to beat our dividend portfolio and make more than 3%. Approximate price we should consider paying for such property is $2,000 * 12 / 3% = $800,000. If we can get a property for cheaper than that, we get an even better cap rate.
What is a good capitalization rate compared to non-real estate investments should also be in your consideration.
Rental properties, like any other investment, pose risks. Ready-made portfolios that we discuss a lot on the site are potential alternatives. Looking specifically at income portfolios, you can find a portfolio that generates close to 5% yearly income. Properties with 2%-3% on paper will be a worse investment, at least from a pure income perspective. We must remember that it is doubtful that we use that much leverage when we invest in stock portfolios. The great benefit of real estate investing is that access to leverage is much easier than stocks or bonds. Therefore, we always have to keep in mind the cost of this leverage. This brings us to Cash on Cash return calculation for rental properties and the downsides of the capitalization rate calculation.
Downsides of the capitalization rate
Figuring out what is a good capitalization rate is only half the story. The most significant part of rental property investing is how easy it is to access leverage. For example, a mortgage is much easier to attain than the same amount would be to get for your stock portfolio. Imagine going to a bank and asking for a million dollars that you want to put into a dividend portfolio. No bank will agree to take on that much risk. Real estate, however, is backed by a real asset, and banks are much more willing to give you money to purchase that asset. Costs associated with borrowing that money are not included in the calculation.
Enter, cash on cash return rate.
The cash on cash return rate is exactly as it sounds. It is a return you earn on the cash you put down to finance the property. But, unlike the cap rate, it includes costs associated with borrowing money and looks at the actual property price that you paid.
Cash on Cash Return = Total Annual Cash Flow (before Taxes) / Total Cash You Put Down.
We have put together detailed cash on cash return calculator to make the calculation as easy as possible for you.
Another downside of these calculations is that they ignore any improvements or any appreciation in the property value. But, again, you have to consider this separately as both cap rate, and cash on cash return rate only look at income. So one possible scenario could be that your initial calculation makes sense from a cap rate perspective. Still, if the property loses value over the following years, it could potentially wipe out any positive return you were earning.
Final thoughts and next steps
Knowing what is a good capitalization rate helps you understand how much rental income you should strive for and the purchase price of the property. It is only part of the overall investment analysis but is a quick and easy calculation to compare investment deals and thus a good starting point. After calculating the capitalization rate and cash on cash return, you should move on to a more detailed cash flow analysis.