In this episode of Coffee with Carl, attorney Carl Zoellner provides a simple formula for calculating cap rates with rental real estate.

 

As you know, I pull my content ideas for Coffee with Carl from our Platinum members’ frequently asked questions. A question I see a lot of involves how to calculate cap rates for rental real estate. Although many real estate investors use a quick mental-math method for estimating the cap rate on a given property, it’s worthwhile to walk through a simple example.

First off, what are cap rates? Cap rates (short for capitalization rates) are calculations performed to measure the performance of a piece of rental real estate. After running the numbers, you’ll arrive at the cap rate, expressed as a percentage, and use that to estimate the potential return on an investment property.

I recommend calculating cap rates on an annual basis for any investment property you hold. This is especially important if you have multiple properties in your portfolio. Calculating cap rates annually will allow you to know what properties are or aren’t performing. However, when first purchasing a piece of property, you have to make some assumptions about actual numbers. 

To calculate cap rates, use the following formula:

  • Gross income – expenses = net income
  • Divide net income by purchase price
  • Move the decimal 2 spaces to the right to arrive at a percentage. This is your cap rate.

Let’s look at an example.

An Example

First, you’ll need to know the annual rental income the property will produce. If you’re considering buying a piece of property that was already a rental, you can usually have this info disclosed during your due diligence period. For our example, let’s assume a rental property pulls in $9,000 a year in gross rental income.

Once you have your gross rental income, subtract expenses. Property management fees are a common expense for investment properties, and these fees usually hover around 10%. For a rental property making $9,000 of income annually, property management fees will be around $900 annually. So, subtract $900 from that $9,000. Other expenses to subtract from gross rental income include annual maintenance costs, property taxes, and insurance. For this example, subtract $450 for annual maintenance, $710 for property taxes, and $650 for insurance. After subtracting these expenses from gross income, you have net income. For our example, the net income after all expenses is $6,290.

Once you know net rental income, divide that number by the purchase price. Next, take that number and move the decimal point two spaces to the right. This gives you the cap rate percentage.

For our example, let’s say the property was purchased for $40,000. Take the net income of $6,290 and divide it by $40,000. This gives us 0.15725. When you move the decimal point two spaces to the right, this gives us a cap rate of 15.7%.

So, again: a simple formula to calculate cap rates is:

  • Gross income – expenses = net income
  • Divide net income by purchase price
  • Move the decimal 2 spaces to the right to arrive at a percentage. This is your cap rate.

Keep in mind that this is a basic formula. As time goes on and you have real-world experience with and numbers for the property, your cap rate calculations will evolve. You can adjust this formula or add additional expenses. There are lots of different methods investors use to calculate cap rates; this is a general and simple formula to figure a property’s cap rate.

 

Watch as Carl illuminates cap rates for investment properties.

 

Resources mentioned in this video
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Got an idea for a future Coffee with Carl? Send it to Carl at cwc@andersonadvisors.com.

 

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