Learning about the cap rate in real estate, and how it relates to your property, will indicate just how profitable your investment is.

Cap rate is a metric often used by real estate investors to get an idea of a property’s future ROI. It is relatively simple to calculate by dividing your net operating income by the market value of your property. Real estate investors do what they do to build their wealth, following their preferred strategy. This investment has led to much growth for those who know how to invest in suitable properties in more recent years.

And many have found their pockets getting deeper and deeper. Unfortunately, though, some investors have found themselves dealing with a nightmare and a drain on financial resources without knowing what to look for or what metrics to use. Learning about the capitalization rate (a.k.a. cap rate) and how it relates to your property will indicate just how profitable your real estate investment is.

What Is Your Cap Rate?

A cap rate is an excellent tool for forecasting your return on investment. It helps you to determine if your property is profitable. For years, investors have used it to determine how well (or poorly) their commercial real estate investments are doing, but it can be used for income-generating residential properties. So, if you’ve got rental properties – pay attention.

As we said above, you calculate your cap rate by dividing your net operating income by the market value of your property. And while this may seem like a confusing or complicated thing to do, it’s relatively simple. Let’s break it down. Follow these five steps to find your cap rate:

1. Determine your property’s gross income. Your gross income for rental property will be the rent that it generates and any other income sources, such as if you have laundry facilities, covered parking rental, storage, etc.
2. Subtract expenses of managing/owning the property. This means subtracting any costs such as homeowner association fees, taxes, insurance, property management fees, etc. But, do not subtract your mortgage payment.
3. Find your net operating income (NOI). To find your NOI, you will subtract your expenses from your property’s gross income.
4. Determine your property’s asset value. To find your cap rate, you have to have a valuation. You can use online sites like Zestimate on Zillow. Or, if you have your method of determining your property valuation, that’ll work. You cannot proceed unless you have it. If you have not purchased the property yet, you could use the purchase price here.
5. Divide your NOI by your market value. Multiply your answer by 100 to get a cap rate percentage.

Go on – try it. See what percentage you come up with.

How Cap Rates Can Help Investors

So, how can you use the cap rate metric to your advantage as an investor? It can help you determine the level of risk involved in purchasing a property. For instance, the higher the cap rate, the more risk involved with the investment. Knowing the level of risk you are comfortable with can help you determine whether you want to proceed with a particular investment or not once you know the cap rate.

Having a good understanding of the local market where the property is located can help you use cap rates. A thriving market with in-demand rentals will have a different cap rate than one in a quiet rural town. This is because rental hotspots will have more costly properties that can churn a higher operating income. Be sure to consider that markets that are in–demand are not always going to be in need necessarily.

And, when things die down, so will the cap rate. Drastically low cap rates may signal that there is little demand. If the property has had a chronically low cap rate, there may not be much hope for long-term improvement. Do your research on the market and learn the ins and outs of the community to get a better feel for the property – and its potential future.

What Is a Good Cap Rate in Real Estate?

If we are honest, a reasonable cap rate will vary from investor to investor. However, some looking to get a good return with negligible risk tend to prefer a cap rate of about 4% to 5%. And many properties fall under this category. Investors willing to take more significant risks and are more aggressive in their approach look for a cap rate of 8% and higher.

Remember, this rate can change over time. Knowing your investment strategy and what works best for your portfolio is essential. This will help you determine the cap rate that works for you, rather than focusing on what others believe is a reasonable cap rate. The more comfortable you get with investing, the easier it will be to use this metric and find your magic number.

How a Property Manager Can Help

Believe it or not, hiring a property manager can positively impact your cap rate. However, we aren’t talking about just any property manager, but rather one that is experienced and can help you lower your expenses on the property. Here’s how it can work.

Property managers are highly-versed in tenant screening and finding high-quality tenants for your property. This means they are often long-term tenants less likely to leave the property with extensive damage or force you to go through the eviction process due to lack of payment. It also means your vacancy rate will be low, too.

Even more, property managers have a team of experts that handle the maintenance and repair of the property – which means you will be able to focus on your future investments while having confidence that you are getting the best deal on any issues at your property.

As you move forward with your real estate investment strategy, take some time to consider what constitutes a reasonable cap rate for you.