Recently I’ve been helping a client invest in rental properties as part of her overall investment and retirement strategy. If you’ve ever considered purchasing income producing real estate, a helpful calculation to utilize when comparing multiple properties is what is known as the capitalization rate (cap rate).
Cap Rate = (Gross Annual Rental Income – Annual Expenses) / Purchase Price
Calculating the cap rate on a prospective real estate investment demonstrates what kind of return a property is generating on its rental income. For example, if the asking price for a property is $445,000, has $5,000 of annual expenses, and is bringing in annual rents of $44,340, simply subtract $5,000 from the gross rental income amount and divide that net rental amount by the purchase price to come up with an 8.84% return. In short, the cap rate is telling you what kind of return it takes to generate X amount of income on a given lump-sum of money.
Calculating the cap rate can also be helpful when negotiating the price of a property. If, for example, you are seeking a 7% return on a property that only has a 6% cap rate, then you can increase your cap rate by negotiating a lower purchase price. Or, in some instances, rents might be below market value, in which case raising the rents might increase the cap rate to the desired level. Although there are many other factors to consider when purchasing income producing real estate, understanding a property’s cap rate is a simple, yet helpful way of analyzing a prospective property.