You may have an understanding that real estate is a solid investment choice. You may even be at the point where you have started looking!
But once you find an investment property, how do you know if it is worth pursuing? Will the property be a good investment for you?
If you don't evaluate your investment return, you could find yourself with a property that doesn't do anything for you. One of the easiest ways to evaluate an investment property is to calculate the cap rate.
What Is Cap Rate?
Technically the cap rate calculation is used to determine value. So you would determine what the “cap rates” of recently nearby sold properties were, and then use that number to establish what a good purchase price would be for a property you are looking to purchase.
That said, I feel like the cap rate is just as commonly used by the buyer to determine if a price being asked for a property is good. So the buyer would say “at that purchase price what is the cap rate?”.
Conversely, if you were selling your property, you would say “if I could sell this property at a 5cap, what would the sale price be? So that's how I've more commonly used cap rate.
There are a lot of metrics out there, but cap rate is an industry-standard. It's an easy way to review the investment value and or return of a property. I will say, however, that it is most commonly used in the commercial real estate space, as opposed to residential.
Of course, cap rate is always just an estimate. Many factors can impact your return on an investment property such as vacancy, expenses, tax increases, etc. You'll want to think about the potential risks and the impact on your cap rate.
How to Calculate a Cap Rate
The originally intended cap rate formula is calculated in the following way:
Annual Net Operating Income / (Cap Rate / 100) = Proposed Value of Property
So, for example, if you have an annual net operating income (NOI) of $5,300 and the cap rates of recently sold nearby properties have averaged 5.3%, you would purchase the property in question at 100K.
Now, if you wanted to determine the cap rate at which you were buying a property, you would use this version of the formula:
(Annual Net Operating Income / Purchase Price) x 100 = Cap Rate %
So, for example, if you have an annual net operating income (NOI) of $5,300 and the property costs $100,000, you'll have a cap rate of 5.3%.
Check out some math here…
This formula is a quick way to estimate what a retrun rate return would be on invested capital if you were to buy the property with all cash. So it's not exactly the same as “cash on cash” in the normal use of that term.
But It's a good general and quick point of comparison when looking at multiple potential investments.
Note that I bolded the statement about assuming you buy in all cash. The expenses included in a cap rate calculation do not include any interest you would pay if you had a mortgage.
However, cap rate is not the end all be all. Real estate investment returns are made up of more than the cash-on-cash return (aka cash flow). To fully understand how a property will perform, you need to do more analysis.
My Cap Rate Calculator
I have both my simple cap rate calculator, as well as my full investment calculator, accessible in my free course on understanding real estate investment returns.
This is a short course where I walk you through how real estate investment returns come together is my full investment calculator. The result of which is commonly referred to as the IRR or internal rate of return.
You can also watch this Youtube video I made discussing Cap Rate and a walking you through my calculator!
More on Annual Net Operating Income (NOI)
Your net operating income is your total revenue for the property, less your total expenses. It's also commonly referred to “Cash Flow”, or the (hopeful) cash you have in hand at the end of the year.
Your income will mostly be the rents from the property but could include other income, if you charge extra for parking or storage.
The expenses will be anything that you need to pay related to the property, from maintenance to taxes to insurance. You'll want to be be conservative when calculating this, and plan for unexpected expenses or vacancy.
The type of lease you enter into with the tenants will also impact your cap rate. If you are buying a property with existing tenants, ask about any existing leases, and understand what the impact of that lease will be on your cap rate.
Types of Leases
The type of lease you have with tenants will impact your cap rate. The lease will drive your overall expenses for the property, which is a factor of NOI.
Understanding the cap rate of the property requires that you know the expenses. Also, know that changing the lease type for the existing tenants could make the relationship rocky or end up with tenants leaving.
Since NOI is based on your income less expenses, you need to have a good handle on both. Think also about variations in expenses from year to year. Are any of the expenses expected to increase, and are you able to increase the rent without risking your tenants?
Different leases have different impacts on your NOI, so it is important to understand each.
Triple Net Lease (NNN)
In a triple net lease (NNN), your tenants will pay all expenses of the property. This can include real estate taxes, insurance, and insurance. If your rental space is an office building, this would also include janitorial or other maintenance services.
In a NNN lease, your rental income is usually lower. However, any increases in expenses are the responsibility of the tenant. This makes it easier for you to calculate cap rate year-over-year because you don't have to factor in increased expenses.
The benefit to the tenant is the lower price point on the rent itself. If the property includes office space for multiple tenants, they can share the janitorial or other maintenance expenses.
In a full gross lease, the rent includes all of the expenses. The landlord pays taxes, insurance, and maintenance.
In a gross lease, the rent is higher because the anticipated expenses have to be covered. However, for the tenant, there is peace-of-mind in not incurring additional expenses each month. The payment each month is known and easy to budget.
As a landlord, you will enjoy a higher rent. However, you will need to factor the expenses into your cap rate and think about potential increases.
Modified Gross Leases
The gross lease tends to be more tenant-friendly, and the NNN lease tends to be more landlord-friendly. In the middle sits a modified gross lease. A modified gross lease is a compromise of the NNN lease and the full gross lease.
In a modified gross lease, the landlord pays some of the expenses, such as property taxes, insurance, and common area maintenance (also known as CAMS). But things like utilities and janitorial services are usually paid by the tenant.
Tenants and landlords can negotiate what expenses are covered by a modified gross lease. It can be any combination of expenses of the property.
Commercial vs. Residential
Looking at cap rate is a bit different for commercial versus residential rental properties. Most tenants for residential properties expect a full gross lease, where the landlord pays all of the expenses.
For you, as a residential investment property owner, the cap right might be less meaningful depending on how you plan to use the property. You may be planning to flip the property or rent it out on a short-term basis (like an Airbnb). These factors make the traditional cap rate calculation less meaningful.
Calculate a Good Cap Rate
When you are looking at purchasing a rental property, you will want to calculate as much information as possible related to the income and expenses. Then think about how your expenses may change over time, as well as any increase in rents.
Use this Cap Rate Calculator to evaluate your cap rate for a property. Make changes to the net operating income or property value to see the impact on cap rate. And think about your own risk tolerance as you determine whether or not a real estate investment is right for you.