Investing in residential real estate can be a lucrative venture that is low risk while giving you the opportunity to get hands-on with your investment. This is a popular type of investment amongst property investors, which is why there’s an increase in foreign investments in U.S. real estate. Part of the draw is the low barrier to entry, both in terms of cost and experience, though there is plenty of complexity as you get deeper into your real estate investing. While there are things you can learn as you go, one of the most important ideas to understand is cap rates. Aside from property management, understanding cap rates will be key to a successful investment. Here is a guide to help you better understand single family rental cap rates.
What Is a Cap Rate?
Cap rate, or capitalization rate, essentially measures the profitability of any real estate investment. When comparing commercial vs residential real estate, this rate is important to consider. It is characterized as the net operating income (NOI) of any given property compared to that property’s asset value.
The cap rate is represented as a percentage that shows how much of the property’s value that you can expect to receive in profits. It is an estimate of your annual return on investment. The higher the percentage, the more that you can expect to make in profits. The cap rate can also be used as a measure of how risky an investment may be. A high cap rate may denote a high risk.
Why Do You Need to Know Cap Rates?
Assuming you have done your due diligence and performed the right calculations, a cap rate gives you a fairly accurate estimation of the potential profitability of a property (with the exception of residential real estate depreciation). Here is why you need to know cap rates for a single-family rental.
Understanding Your Operating Costs
Whether you are a seasoned veteran or taking your first steps in investing, understanding your operating costs is essential to understanding the potential cash you may get out of your single-family property. Overhead, management, maintenance, taxes, a new HVAC, and other unforeseen costs can easily get bigger than you ever expected.
Calculating your cap rate gives you a much more nuanced picture of your operating costs. You can see the larger picture of how much you are putting into a property while getting granular to see expenditures that may be suspiciously large or otherwise unnecessary and adjust accordingly. For example, you may realize that a property has unexpectedly high utility costs from an outdated, inefficient HVAC system.
Identifying Your Investment Options
As an investor, you likely have multiple properties that you may want to invest in. Among other factors, calculating the cap rate for each property allows you to estimate the potential return on investment of each house. You can then weed out the properties that are not worth it. This is a quick, easy, and relatively concrete method of determining profitability, as opposed to looking at the constantly fluctuating market rents and purchase prices.
When Cap Rates Do Not Apply
Cap rates are an important tool, but they mostly apply to properties you plan to rent out, which is even easier with single-family homes. It is less effective on other property types used for investment, which includes:
Fix and Flip Homes
Fixing and flipping homes is hugely popular, but cap rates are not particularly useful here. Real estate investors wanting to flip properties want a quick profit from selling the property, as opposed to earning a rental income over a longer term, which ultimately makes the cap rate null and void.
Vacant Rental Properties
You can absolutely calculate the cap rate of a vacant rental property, but it may not be the most reliable approach. Estimating the cap rate usually requires some knowledge of the property’s net income. If you don’t know the rental income, you may have to rely on estimates and rough projections. This can still be useful, but it will not be as precise as you want.
How to Calculate the Cap Rate
In its most basic form, calculating the cap rate simply involves dividing the net operating income by the total property value. This cap rate formula sounds simple enough, but the rate calculation gets a little more complicated in practice. Remember, to get the most accurate estimated cap rate calculation, you want to be as comprehensive as possible.
Step 1: Determine the property value.
Determining the current market value of a property usually comes down to checking classifieds or online listings. You can also contact a broker or appraiser to determine the asset value and get a better idea of current market rates in the area.
Step 2: Determine your net operating income.
Determining your net annual operating income is a much more involved step. Start by adding up all of your expenses except for your principal mortgage. That includes:
- Property management costs
- Home equity loans
- Homeowners fees
The exact expenses can vary from person to person but try to be as thorough as possible to ensure accuracy. Once you have added up all of these expenses, subtract that from your gross net income, which mostly comprises rent but may also include any parking fees you are collecting and in-unit laundry, if applicable. That gives you your net operating income.
Step 3: Get your cap rate.
Once you have the two numbers, simply divide your net operating income by the property value. That gives you the rate calculation as a percentage.
Factors Affecting Cap Rate
While your operating costs can affect your cap rate, the two main factors that contribute to the cap rate are the location and interest.
Location is one of the most ubiquitous and significant aspects of real estate, and the cap rate is not exempt. Demand, employment rates, school zones, and median household income all vary based on the location and contribute to what makes certain cities the best places to buy rental property. That ultimately contributes to the market value of houses in the area, which affects the cap rate. For example, cap rates and property management in Gainesville, FL may be quite different than that of in Texas.
Granted, some real estate investors will allow for lower cap rates if the property is in a major market. Others may avoid high cap rates in a housing market that seems risky or lacks in the fundamentals.
Debt is one of the biggest contributors to real estate investment, so interest rates naturally influence a variety of metrics. Cap rates can fluctuate widely based on interest rates in a given area. A low cost of borrowing also tends to lower cap rates.
What Is Considered a Good Cap Rate?
Once you have calculated your cap rate, you are probably wondering what actually constitutes a “good” cap rate. Determining a good cap rate can be challenging. Remember, location is one of the most prominent factors that can affect cap rate. A cap rate that seems low in one part of the country may seem perfectly reasonable elsewhere, which is why you should mainly look at the specific market that you plan to invest in.
For most investors of single-family properties, a cap rate around 10% or more is considered ideal. However, many investors can still benefit from properties with cap rates around 7-8%. Some investors can even profit from properties with 5-6% cap rates.
Much of this comes down to the local market. A lower cap rate may be fine if your property is in a larger housing market with constant and high demand, while a higher cap rate may not mean much in a smaller market with less demand. For example, many investors will be fine with a cap rate of 7% or lower in Los Angeles. That same cap rate may not be recommended in other locations of the country.
Equip Yourself with the Tools for a Successful Investment
Cap rates are an incredibly important measurement for investors, but they are just one tool in your arsenal. No single metric will provide you with all the information that you need. That said, cap rates are a great place to start as you gather more information and knowledge for further real estate investing. When looking to invest in a great rental property, make sure that you equip yourself with enough real estate knowledge and a number of tools like property management services. It’s important to remember that there is no single factor that’s responsible for a successful investment. Whether you need property management in Indianapolis, IN or Jacksonville, FL, reach out to our team of professionals today if you want to get the most out of your investment.