When searching for rental property, research is important. Your purchase decision must be based on more than it’s income producing potential. You also have various costs to consider.
Additionally you have to ask and answer an important question. “Will I see a greater return on this investment compared to similar rental properties?”. While the question itself is simple, the answer is not so obvious.
There are several ways to calculate a rental property’s value. One of which is the cap rate approach. Like any other investment calculation, you take the result of this metric and compare it with the results of similar properties.
To accurately interpret a rental property’s calculated cap rate the comparable properties should be like-kind with the focus on the following qualities.
- Condition
- Quality
- Location
- Is the area growing or stagnant?
- Income and expenses
- Income levels in the area
- Cost of acquisition
- Quality of available tenants to choose from
Calculating Cap Rate on Rental Property
The Cap rate for rental property is calculated by dividing the property's net operating income (NOI) by its current market value (or your acquisition cost). Here is the formula:
Annual net operating income (NOI)/the property’s market value
For simplicity, let’s use for our example a property you’re considering to purchase is selling for $1 million dollars. This property is returning $50,000 in net operating income (NOI). Calculate your cap rate by dividing the $50,000 NOI by the $1 million property value. You get a cap rate of five percent.
$50,000/$1,000,000 = 5%
You’ll use this value for your property comparisons. The risk and potential return are tied to the cap rate. Cap rates on the high end have a corresponding potential for a higher return. As an investment rule it’s important to remember that higher return potential also means that risk increases as well.
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