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What is “Cap Rate?” … and Should You Care About It?

Sheri Sperry June 13, 2023

SellSedona.com, Sheri Sperry, ReMax Sedona,

Two Main Things An Investor Wants to Know...

1. Is there a rental history on the property?

2. What is the cap rate of the property?

Key Point: If you are dealing with investors, they will understand what "Cap Rate" is, so it is essential that you understand the term. questions question questions

Capitalization Rate or "Cap Rate"

  The cap rate is a term that can confuse most people. Different calculations can be used to determine the cap rate and income expectations. It is my opinion that if you are buying real estate for investment purposes, you should make sure you are constantly comparing "apples to apples"!  You don't need to concern yourself with the cap rate if you do not use this property for income.

So What's the Bottom Line?

  The simple explanation for Cap Rate is Net Operating Income divided by the Property Asset Value or Market Value - (NOI / Property Asset Value). Because rental properties are usually very different, it can be challenging to determine the fair market value of a property. A property with lower expenses and higher rental potential will command more on the market than one with higher expenses and lower rents.  When buying a home, this is a very personal choice, not so much when buying an investment property. Cap Rate helps to determine what the value of the property is to you. In other words, what type of annual return do you want to get?

Sounds simple enough, right? - Not So Fast!

  Where you can get into the weeds is when you start comparing properties. If you do not do the assessment of the cap rate yourself, find a person you trust who can compare and vet the data and will do it the same way on every investment opportunity.

Tip: You might want to use a form or "cheat sheet" with all the income and expense variables listed so you do not miss any categories.  Homes or duplexes will be much easier to calculate than dealing with commercial properties or apartment buildings.  With commercial real estate, there may be added costs or expenses such as Management company, marketing, permit fees, taxes, and other costs that you may not be aware of in the local area. Having a professional help specify the finer points of a possible purchase is always a good idea.

Homes Profit and Loss ROI

Rental History vs. NO Rental History

  If you have a rental history and expense history, the cap rate will be more accurate than any estimate.  You also need to figure out the vacancy rate for your area.  Here is an example. In West Sedona, finding a home to rent is sometimes very difficult. This would indicate that the vacancy rate may be below the national average of 6.4%.  It is essential to figure out the vacancy rate. A reliable property management and rental company can give you that information.  In Sedona and the Verde Valley, I can help with that information. Contact Sheri Sperry. Also, if you have a property where you will need a property manager and are considering a tenant as the property manager, any discount in rent should be included in your operating expense. Check with your financial advisor to determine the appropriate expense. After all, you would have to hire a property manager. Here are some of the rental property expenses that investors must consider.

~ Property Management ~ Property Improvements ~ Property Taxes ~ Homeowners Insurance ~ Utilities ~ Tenant Screening ~ Marketing ~ Accounting Fees ~ Business Permits ~ Vacancy Costs - HOA Costs ~ Maintenance ~ Mortgage ~

~ Plus, all the costs associated with buying and selling a property ~

Download this simple spreadsheet for rental property analysis

Spreadsheet Courtesy of Roofstock

What Is An Acceptable Cap Rate?

  There is no simple answer in this quest to find the right property. Only you can determine what may be acceptable. Basically, the cap rate helps you determine what kind of annual return you will get on the money you invest in the property.  It can also determine what you should pay for the property. The formulas below will assist you. My personal opinion is that a return of less than 5% could put your investment at risk and require infusing more money into the property if something happens that is unexpected. Better yet, a 7% to 9% Cap Rate is less risky and is preferred by investors. Some refer to infusing money into the property as a capital call. This is especially true when other investors are involved, such as in a partnership or corporation. It may involve a substantial repair, remodel or build-out for a tenant. The money must be funded using a capital call if very little is in reserve. The higher the return, the more value the property holds. This also helps to keep more in reserve to minimize the risk of a capital call.  
  • Net Operating Income (NOI) = Annual Rent minus Annual Expense.
  • Cap Rate = NOI divided by Market Value or Property Assessed Value.
  • Property Assessed Value = Annual Income divided by Cap Rate.
  Home Expense Profit and Loss

Note: Vacancy rate will periodically change. Check your area to see the current vacancy rate.

Four Reasons To Own Rental Property

  • Property Appreciation

    • In today's market, think long-term. Five years minimum.  Even better, 7 to 10 years.  NAR estimates a 6.74% appreciation annualized over the last 50 years.
  • Mortgage Reduction

    • If you purchase wisely, your tenant is paying your mortgage payment.  Consider the rental income average for the area the property is located in.
  • Tax Benefits and Deductions

    • Besides depreciation and deducting mortgage interest, there are deductions for travel, HOA fees, repairs, home office, cell phone, maintenance, etc... This adds up quickly.
  • Cash Flow

    • If you analyze the property correctly, there will be cash flow.
Each of these items contributes to the ROI.  Of course, there are risks involved. But a solid analysis will help to minimize the risks. Always involve your tax or property advisor to help you with your analysis.

10 Reasons Why Sheri Is Your Solution

Please contact me to discuss how I can help you with all of your real estate needs. I want to help you navigate through the process. I love helping people buy and sell homes – it’s my expertise and what I do! See more here.
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