Evaluating Investment Property Profitability With Cap Rate

The first questions anyone asks when purchasing an investment property are (1) will I make money on this investment and (2) if so, how much? The answer to these two questions can be simplified into a single number called the Capitalization Rate, or “Cap Rate”. In this article, we discuss what a Cap Rate is, how it is derived, and how it is used.

What is A Cap Rate?

Stated simply, a property’s Cap Rate is its annual net operating income divided by its current market value. The higher a property’s Cap Rate, the more income it generates relative to its current market value. Accordingly, the Cap Rate communicates not only whether a property generates income, but also how effectively the investment is generating income. If a property is extremely expensive but generates minimal income or a loss, the Cap Rate will be close to zero or negative. On the other hand, if a property is relatively cheap and generates significant income, the Cap Rate will be higher.

Determining The Cap Rate’s Annual Net Operating Income

There are two components that comprise a rental property’s net operating income. The first is the rental income that the property generates, which can be easily calculating by multiply the monthly rent by 12. The second is the property’s expenses, which typically are comprised of the mortgage interest payments, property taxes, insurance, and other miscellaneous expenses (e.g. repairs, management fees, etc.). The property’s annual net operating income is then obtained by subtracting the annual expenses from the annual rental income.

For example, let’s assume the following: Mr. Investor is considering purchasing a property for $1,000,000.00.  The property generates monthly rental income of $20,000.00 (let’s assume this number accounts for potential vacancies). Mr. Investor plans on obtaining a loan to purchase the property, and the interest portion of his loan payments is approximately $2,000 per month. Mr. Investor also has monthly expenses of $200 for insurance, $1,000 for property tax, and approximately $500 in monthly maintenance expenses. In this case the annual net operating income is 20,000 * 12 – (2,000 * 12 + 200 * 12 + 1,000 * 12 + 500 * 12) = 240,000 – 44,400 = $195,600.00.

Current Market Value’s Affect On Cap Rate

The market value of a property plays a significant role in determining its Cap Rate. Because a property’s market value is constantly changing, it is important to regularly re-assess a property’s Cap Rate to determine whether the investment is generating sufficient income relative to the property’s value.

In the above example, the Cap Rate of Mr. Investor’s property is 195,600 / 1,000,000 = 0.1956 when he first acquires it. However, if we assume the real estate market experiences a boom resulting in the property’s value increasing to $1.5m, while rental rates remain the same, then the Cap Rate is reduced to 195,600 / 1,500,000 = 0.1304. Convesely, if the real estate market crashes resulting in the property’s value decreasing to $500,000, with rental rates remaining the same, then the Cap Rate increases to 195,600 / 500,000 = 0.3912.

How To Use The Cap Rate

When acquiring property, the Cap Rate can be used to compare the profitability of different properties. As noted above, properties with higher Cap Rates promise a higher return on investment, while properties with lower or negative Cap Rates are less desirable. In short, it can be used as a single number to effectively compare different investments.

It is also important to regularly re-assess a property’s Cap Rate in order to determine whether the investment continues to generate value. As shown above, the market can significantly affect a property’s profitability. If an investment’s market value increases with little change in rent, it may make sense to re-invest the funds into a property with a higher return.

In sum, the Cap Rate is an extremely effectively tool to streamline both comparing different investments as well as continually assessing an investment’s profitability.

For more information on how Esquire Real Estate Brokerage, Inc. can help you in the Los Angeles real estate market, feel free to give us a call at 213-973-9439 or send us an email at info@esquirereb.com.