# Understanding Cap Rate

The quickest and most effective method of analyzing a rental property is by calculating its CAP RATE. Cap rate is a financial ratio which is used to compare similar real estate investments by analyzing the expected income as a percentage of an all cash purchase price.  In short, you divide the annualized net income into the acquisition costs. It is important to note that cap rate ignores the financing costs and assumes the project is bought with one hundred percent cash.

The lower the cap rate, the lower the ROI. The higher the cap rate, the higher the ROI

Calculation of Cap Rate

First, calculate the sum of all 12 months of expected rent income…

…then subtract 35% (10% for property management, 10% for vacancy rate, 10% for capital expenditures, and 5% for maintenance and repairs.)

…then subtract the estimated taxes…(The annual school and city tax expense can be found on your local city government site, town clerk website, or simply ask your real estate agent.)

…then subtract the annual estimated insurance expense and the annual estimated water expense. The number you are left with is your annualized net income.

The final step is to divide your annualized net income into the acquisition costs which will be the purchase price (without closing costs, inspection fees etc.) plus any rehab expense which is necessary to make the property rent ready.

((annual gross rents) – (10% property management fee, 10% vacancy rate, 10% capital reserves, 5% maintenance/repairs) – (annual taxes) – (insurance) – (water)) / (purchase price + rehab expense)

Example

• Purchase price – \$52,900
• Rental Rate – \$1200/ mo
• Taxes – \$3,300
• Insurance – \$600
• Rehab costs – \$27,500

For multi-family, the owner pays for the water bill but for single family, the tenant pays. It is illegal to charge tenants in a multi-family for water if they are not separately metered.

((\$1,200 x 12) x (0.65) – (\$3,300) – (\$600)) / (\$52,900 + \$27,500) = 6.79%

How to Use Cap Rate

Use cap rate to compare similar investments in your local market. After a while you will begin to get a feel for the cap rates in your target area and be able to jump on a killer deal as it hits the market.

The most desirable neighborhoods will have a lower cap rate:

1. Park Ave 1-3%
2. East Ave 1-3%
3. Monroe 3-6%

The upcoming neighborhoods will have a higher cap rate

1. South Wedge 4-7%
2. 19th Ward 7-13%

In theory, the rental properties that are in the best locations which come equipped with newer mechanics, roofs, cosmetics, appliances, etc. will be viewed as a low risk investment as a result investors are willing to accept a lower rate of return.

On the other hand, you will notice that in some of the worst neighborhoods the cap rate can get as high as 15%! Higher cap rates may look appealing but they’re 99% of the time influenced by high vacancy rate, high maintenance costs, and will also take a lot more time managing than rentals in better neighborhoods.

Most people calculate cap rate differently but I like using the most conservative numbers. What you need to remember about cap rate is that your calculation MUST stay consistent with your numbers. DO NOT decide to compare two investments with different vacancy rates or property management rates. Don’t rely solely on cap rate but use it as a quick tool to see if a property is at least worth taking a look inside.