Cap Rate to Shoot For on Virtually any Rental Property
To figure out the cap rate, the equation is:Annual NET Income / Purchase Price = Cap Rate
Some notes concerning this equation, and therefore what a cap rate includes or tells you (or doesn’t tell you):
Net income. Note that you must utilize the net income on a property, not the gross. The net income is just what you will get after all expenses are taken out.
Mortgage payment. The cap rate does not incorporate a loan payment. So don’t count that among your expenses while you are calculating your net income.
Adjusting purchase price. When you are buying a property needing rehab, your purchase price needs to be the total cost including the rehab. Whatever it takes to purchase the house and then for it to be rentable, that’s the number you should use.
The most important thing you have to know before being concerned about what cap rate to look for is:
Cap rates will vary between markets, property types, as well as other factors. So remember when you are analyzing cap rates, you have to compare apples to apples – not apples to watermelons.
Specific factors that could affect cap rates include, but aren’t limited to:
Your specific market. Just due to simple real estate economic variances between markets, the “going” cap rate associated with a market is likely to be different from that of another market.
The area within a given market. This relates to different areas inside of a market. For example, more desirable areas in comparison to less desirable areas.
Property type. Generally, this would relate to single-family properties versus multifamily properties. Multifamily properties inherently include more risk than single-family properties (mostly because of the tenants). Since they are typically higher risk, the cap rates are usually higher to make up because of it. Because single-family properties are generally less risky, it wouldn’t make sense to buy a multifamily property that has a lower cap rate than the usual single-family property. (Note: this doesn’t include risk with such multifamily properties as high-end condos or anything like that – these statements refer to comparable properties in similar areas to each other.)
Property condition. It certainly wouldn’t seem sensible to buy a dumper that has the same cap rate as a freshly rehabbed, good shape property.
Risk factor. This includes risk associated with neighborhood, property type, and the property condition. Think about it in terms of a trade-off. Why might you purchase something with greater risk that has exactly the same cap rate as a property with lower risk? Your two biggest risks with any property will be with the property itself (think massive repair costs that break your bottom line) and the tenants who reside in it (bad tenants are arguably the most costly thing to a rental property owner). One other major risk is vacancy, which is most directly impacted by the neighborhood or market itself.
Economic cycles. The real estate economy of any market is not only dependent on the nationwide real estate economy, but on its own economy too. The existing place of a market in its economic cycle will have a major impact on the going cap rates at any particular time.
Below are a few different scenarios of varying cap rates, along with each, we will explain why the cap rates differ.
A 5% cap rate will be considered fantastic in Los Angeles, but horrible in Kansas City. Reason: Market Differences
The cap rate with a cute little house in the quiet outskirts of a big city might be 8%, while a similar cute little house in the popular, desired area in the center of the same big city may only enable you to get 1% (if even that!). Reason: Neighborhood Differences
A multifamily property has a cap rate of 11%, while a single-family property in the same general area has a cap rate of just 8%. Reason: Multifamily vs. Single-Family
There are two nearly identical houses, and one is priced to offer a 9% cap rate, and the other provides a 14% cap rate. One of the houses is in “good as new” condition, and the other needs an excessive amount work. Which do you think is associated with which cap rate? Reason: Property Condition
A 7% cap rate for any single-family home in a very nice stable neighborhood inside the good part of Dallas would be excellent, but it will be horrible for a triplex in the more urban Section 8 areas of Chicago. Reason: Risk Factors – Neighborhoods, Property Types, and Tenant Pool
See how a number of trade-offs work and just how they come into play when examining cap rates?We constantly have people asking, “What cap rate do I need to expect on a rental property?” The reality is that question just can’t be answered easily. You might be capable of getting away with having a hard minimum, say 5%, but what if a proposed property was a run-down multifamily in a slightly sketchy neighborhood? Would you still accept a 5% cap rate on that property? Well, maybe we’d if there was solid evidence that the sketchy neighborhood was about to be gentrified and it also was nearby a city like Los Angeles that experiences big appreciation waves. But for a run-down multifamily in a slightly sktchy neighborhood in some small Midwestern city? Not a chance!
And thinking about this whole concept backwards, make sure you always take into account that an increased advertised cap rate doesn’t always mean it’s a better deal. Remember, advertised or projected returns are simply just that – projected. What really matters is whether or not the number will hold true, and a lot of that depends on the quality of the location and property.