If you’re in the market to purchase an investment property, there are a number of factors that will come into play when determining what to offer the seller, namely the rental property cap rate. Unlike buying a personal residence, it is How to Determine the Cap Rate on a Rental Property Purchaseimportant to keep emotion out of the equation – otherwise, you could find yourself paying way too much.

Just like any other type of financial investment that may come up, prior to moving forward on a piece of rental real estate – regardless of how “perfect” the property may seem – one of your key considerations will include the capitalization rate, or cap rate for short.

What Exactly is the Cap Rate?

A property’s cap rate, or ‘capitalization rate’ is the ratio of net rental income in relation to the purchase price of the home. Knowing this figure will help you to know whether the purchase will be worthwhile, or if you should move on to something else that may be more profitable for you.

In figuring out your rental property cap rate, you need to start with the annual gross rental income. If the property is already occupied by a tenant, you can use what they are currently paying (or what the amount will be adjusted to). If the property is empty, then you should get an idea of what a property of that size, with those amenities, in that particular location will likely be able to pull in. (If you are considering a multi-unit property or building, it is a good idea to subtract 5% or so in order to account for the occasional vacancy).

You will then need to determine all of the operating expenses that you will pay out over an annual time frame. These will include utilities (the ones that you will be paying for), as well as insurance, taxes, and maintenance.

Then, subtract the total amount of annual expenses from the property’s gross annual income. This will give you the property’s net annual income. From there, take the net annual income figure and divide it by the potential purchase price.

As an example, if you are considering the purchase of a multi-unit property that brings in a gross annual income of $100,000 and that has yearly operating costs of $30,000, then the net operating figure would be approximately $70,000. If you were to pay $1 million on this property, then, your cap rate would be 7%. ($70,000 is 7% of $1 million).

Knowing that, you can then decide whether 7% will be an acceptable return for you on that property. In some cases, if it is in good condition and is located in an area of town where you can expect it to appreciate, then having a lower-risk but reliable rate of return between 5 and 10% could be a good deal.

If, however, the property is in need of major renovation and / or is located in an area where you may or may not be able to obtain an increase in its value, then you may want to consider moving on to another potential deal.

Obtaining a Good Return on Your Time

Once you have purchased an investment property, you could find that managing and maintaining it takes more time than you anticipated. In this case, using the services of a property manager can help you to free up your time from these obligations, while at the same time still reaping benefits from your real estate investment.

For more information on how to leverage your time by hiring an experienced property manager, Contact Us.