One of the most important skills for any type of investing is knowing a good deal when you see it. The best way to decide what’s a good deal is to determine how much money the investment will earn for you and consider that against the cost of the investment. For some investments, it’s easy to know the expected income stream. For example, with stocks, you can look at the dividend payments.
With rental real estate, it’s more difficult to determine factors like the expected income stream and the market value of the property. It’s much more likely that some of your tenants will fail to pay on time than for a blue chip corporation to fail to pay dividends. It’s also easier to determine the market value of a company’s shares because of the liquidity in the stock market. You don’t need an appraisal to know the value of a stock.
So, what’s a good way to value rental real estate? That’s what this article is about. Here, we’ll discuss the rental property cap rate and how it can help you decide if a property is a good investment. We will show you how the rental property cap rate can help you decide on the right purchase price and the right rent to charge. Last, we will discuss what a good property cap rate is and explain the 2% rule. Read on to see how to use the rental property cap rate to spot the best rental real estate opportunities.
What Is a Rental Property Capitalization Rate?
The rental property cap rate is the ratio of the property’s net operating income (NOI) to its current value. The NOI for this metric typically won’t include the cost of debt service for a loan to purchase the property.
NOI is the easier term to understand. It’s the total of all rental income less the expenses related to the rental units. The expenses include items like repairs, maintenance, and taxes on the property.
What is the current value of the property? Unlike high-liquidity investments such as stocks, you may need an appraiser to give you a good idea of rental property values. Otherwise, you may pay too much for the property. The optimal purchase price is much easier to determine than the best sale price. That’s because you can calculate an intrinsic value based on the expected income, expenses, and value using the rental property cap rate.
On the other hand, the right sale price is very difficult to know. You could make a deal to sell the property today for a price greater than you ever imagined — only to be disappointed tomorrow when another potential buyer offers twice what the buyer today offered. You buy based on rational calculations like the property cap rate. But you may sell based on a buyer’s irrational expectations.
Now that we know what the rental property market cap rate is, how do we calculate it? That’s what we’ll cover in the next section.
How To Calculate Cap Rate for Your Rental Property?
The calculation for the rental property cap rate is easy — it’s the NOI divided by the current market value. It gets a little more difficult when determining what the NOI and the current market value numbers should be.
The current market value is whatever the amount is that the seller will take for you to purchase the property. They’ll usually advertise their asking price. It’s up to you to determine if the asking price is a good deal. Your offer may be lower than the asking price, as there is often some bargaining with major purchases.
Once you know how much you’ll pay, you have your current market value. Now, what’s your expected income and expenses? One way to come to a number here is to look at the books for this property or comparable properties in the same area. You’re interested in the rental income versus the operating expenses. Some of the primary operating expenses include repairs, maintenance, and property taxes.
Next, consider the trend in the area where you’ll purchase the property. Are rents increasing annually? Are local regulations preventing adequate rent increases? Is compliance with local regulations causing expenses to increase more than in other areas? Will a new school in the area increase your property’s attractiveness to potential tenants? These are all factors to consider when determining your expected net operating income.
Now that we know the factors to consider, let’s look at some real-world examples of the rental property cap rate calculation.
Examples of How To Calculate Cap Rate for Investment Property
Example 1 below is a situation where you’re trying to decide if a rental property represents a good buying opportunity based on the market cap rate.
Example 1:
Price You’re Willing to Pay:
2,000,000.00
Gross Rental Income per Year
250,000.00
Operating Expenses per Year
(75,000.00)
Net Operating Income
175,000.00
Cap Rate (175,000/2 Million)
8.75%
In this case, if a rental property cap rate of 8.75 fits what you’re looking for, $2 million is a good price.
What about a case where it’s two years after you purchased the rental property and the property value has risen by 10%? Just to make it more interesting, let’s also say the local government enacted new regulations that will increase your operating expenses by 20% per year. You need to raise the rent, but how much should the increase be to keep your cap rate at 8.75%? That’s what we’ll determine in Example 2 below.
Example 2:
Two Years Later — Rent Increase to Keep Same Cap Rate
Current Value
2,200,000.00
Gross Rental Income per Year
282,500.00
Operating Expenses per Year
(90,000.00)
Net Operating Income
192,500.00
Cap Rate (192,500/2.2 Million)
8.75%
In this calculation, the value increased by 10%, so now it’s worth $200,000 more than in the first example. The operating expenses increased by 20%, meaning the $75,000 operating expenses for the first year are now $90,000. To keep your rental property cap rate at 8.75%, you’ll need to increase the combined rental income from $250,000 to $282,000.
Let’s go back to step 1. You’re trying to determine how much to pay for the rental property. You have decided that you want a cap rate no lower than 8%. If you divide a cap rate of 1 by 8%, you’ll get 12.5. This means it will take 12.5 years for the aggregate NOI to equal the cost of the property. If you increase the purchase price, the cap rate decreases. If you increase the expenses, the cap rate also decreases.
In Example 3 below, we’ll assume everything stays the same as in Example 1, except we have decided that we will calculate our maximum offer price based on a minimum cap rate of 8%.
Example 3:
Calculation of Value Based on Desired Cap Rate
Price You’re Willing to Pay:
2,187,500.00
Gross Rental Income per Year
250,000.00
Operating Expenses per Year
(75,000.00)
Net Operating Income
175,000.00
Cap Rate (175,000/2 Million)
8.00%
So, our maximum offer price will be $2.1875 million.
As you can see, there are a few ways to use the rental property cap rate. But it also has many limitations. The cap rate formula only uses a one-year time horizon. A better way is to use future cash flow estimates discounted to their present value. Since conditions can vary greatly from year to year. By using more years, we could smooth some of the variance out.
The cap rate formula is a good rule-of-thumb calculation. It isn’t the most accurate metric, but it can narrow your choices of which properties to examine in more detail. If you have a great cap rate, it may be enough to make a buying decision, but what is a great cap rate? We’ll explore that in the next section.
What Is a Good Cap Rate for a Rental Property?
The first question to ask is how risky is this rental property investment? The riskier it is, the higher the cap rate you’ll want. For example, if the investment is very low risk, do you care if it has a 5% cap rate — meaning it will take 20 years to fully recover your investment? On the other hand, for a high risk investment, you want your cap rate to be high — like 10%, 15%, or more.
The shorter the time to recover your investment, the less the chance of a loss event occurring. Also, with the higher return rate, you’re making more money to cover any potential losses in a given year.
Your capitalization rate is the return on investment without considering debt servicing expenses. It’s a good idea to split your rate of return between the risk-free rate and the risk premium. The risk-free rate is the return you can get from investing in treasury bills. If the T-bill rate is 4.5% and you have a 10% return on your rental property investment, you could consider 5.5% (10% less 4.5%) as your compensation for the risk you’re taking.
Consideration of the risk-free return against the total rate of return is a good measure for any investment. Risk analysis of different property investments can help you decide what your best rental real estate investment opportunities are.
What Is the Cap Rate 2% Rule?
If you look around the internet, you’ll see that the 2% rule means commercial properties with monthly rent of 2% of the purchase price. You’re going to have a difficult time finding these properties that have a gross yield over 20% per year.
The annual cap rate 2% rule can mean any cap rate under 2% isn’t good because it’s too close to the risk-free rate of return — the 3-month treasury bill rate. In early April 2022, this risk-free rate was less than 1%. In April 2023, it is close to 5%. Through the entire 21st century, the risk-free rate has only been above 2% for a few months. In the 2020s, the outlook is for continued higher rates.
So, we have to ask, does the 2% rule make any sense anymore? Maybe it should be a cap rate 4% rule or cap rate 5% rule.
Key Takeaways
- The rental property cap rate is the net operating income (NOI) divided by the current value
- The rental property cap rate is a good starting point for determining the value of the property
- The rental property cap rate can help you decide how much you should increase the rent by
- When you decide how much your rate of return should be to cover the risk you’re taking, add that rate of return to the risk-free rate (the 3-month T-Bill rate)
One way to keep your rental property cap rate high is to keep your insurance expenses low. The best way to keep your insurance rates affordable is to go with Steadily, America’s best-rated landlord insurance company. You can get a free quote online. Or, you can talk with a live agent by calling (888) 966-1611. We look forward to hearing from you.
