Thinking about buying a rental property? The cap rate is a very important tool for measuring potential income and risk.
What Is Cap Rate?
Cap rate (capitalization rate) is a percentage that shows how much annual income a property generates compared to its purchase price. Think of it as your property's "interest rate" – it tells you what return to expect on your investment.
Understanding Cap Rate Numbers
- Higher cap rates (8-12%): More income potential, but usually higher risk
- Lower cap rates (4-7%): More stable, lower-risk investments with modest returns
Most rental properties fall between 4-12%, but there's no universal "good" rate. It depends on your goals and risk tolerance.
How to Calculate Cap Rate
Cap Rate = (Net Operating Income ÷ Property Value) × 100
A Simple Example:
- Annual rent: $86,400
- Annual expenses: $48,000
- Net operating income: $38,400
- Property value: $500,000
- Cap Rate: 7.68%
Cap Rate = ($38,400 / $500,000) × 100 = 7.68%
This means you earn $7.68 for every $100 invested.
What Affects Cap Rates?
- Location: Prime areas have lower cap rates (higher prices, stable income). Less desirable areas have higher cap rates (lower prices, potentially higher risk).
- Market conditions: Rising rents boost cap rates. Rising property values lower them.
- Property condition: Well-maintained properties command higher rents but cost more upfront.
Making Smart Decisions
Cap rate gives you a quick way to compare properties and understand potential returns. But don't rely on it alone – consider location trends, property condition, and your long-term goals.
Ready to explore rental property opportunities? Understanding cap rates puts you ahead of investors who buy on emotion instead of numbers. Call us today for a free mortgage quote!