How to use cap rate to make your investment property decisions

Written on February 28, 2018 by

communicationThree days ago, my car died on my way home from work. As it turned out, the part to fix my car cost 60% of my car’s current value.

I kept mulling over that number, wishing there was an equation that would help me make a decision. Do I fix my car or do I get a new one? If there is such an equation, I never found it. But there is an equation to help you make decisions on investment properties. Using a cap rate, landlords can make decisions on what types of properties to invest in, what to offer, when to buy, and when to sell.

What is a cap rate?

A cap rate is a simple equation to use to make investment decisions. It’s the first equation that investors use when evaluating properties. This rate uses costs and income to determine a percentage—usually between 5% and 10%. The higher the percentage, the better the investment.

Incomeexpenses/value = cap rate

To determine the cap rate, you first need some information on the property.

  • Current or predicted rental income for the property
  • Vacancy loss in the area
  • Expected maintenance costs on the property
  • Property manager cost
  • Utility costs paid for by the landlord
  • Advertising costs
  • Property taxes
  • Interest paid on loan
  • Current value of the property

You can find many of these answers through property listings, your realtor, or good old-fashioned Google.

Related: How to set the perfect rent price for your rental properties

How do I decide if a property is a good investment?

To determine if a property is a good investment, do the math to find its cap rate. If it’s closer to 10%, it’s a good investment. When you are in the market for an investment property, keep the decision analytical—no emotions. Compare multiple properties, and choose the property with the best cap rate. It’s as simple as that.

For example, landlord A is seeking out a multi-family in Chicago, IL, in the Rogers Park neighborhood. They are looking at three properties.

Property #1:

  • Value:  $700,000
  • Average expenses/year:  $20,000
  • Expected rent:  $72,000
  • Cap rate: $72,000$20,000/$700,000 = 7.43%

Property #2:

  • Value:  $415,000
  • Average expenses/year:  $23,000
  • Expected rent:  $54,000
  • Cap rate:  $54,000$23,000/$415,000 = 7.47%

Property #3 :

  • Value:  $500,000
  • Average expenses/year:  $30,000
  • Expected rent:  $48,000
  • Cap rate:  $48,000$30,000/$500,000 = 3.6%

By using the cap rate, Landlord A can see that Property #1 and Property #2 have a similar cap rate, but that Property #3 has a lower cap rate. From there, Landlord A can make the decision to cut Property #3 from the options and choose based on other factors such as location, improvement needs, and future value predictions.

Related: A beginner’s guide to real estate crowdfunding

How much should I offer?

Property investors can use this rate to determine what to offer, too. If Landlord A decided on Property #2, but wanted to get to an 8% cap rate, they can use this equation to make a decision on what to offer. Subtract the average annual expenses ($23,000)  from the expected rent ($54,000), and divide by .08. Now, Landlord A knows that if they want an 8% cap rate, they need to reach a deal at $387,500 or less.

What type of property should I invest in?

When looking into real estate investments, landlords should consider different types of properties using the cap rate. Don’t assume that a residential duplex is the best bet for you because that is what you have done in the past. Look at cap rates for commercial and residential single family, duplex, 3-4 units, and apartment buildings. Look at all options, find the best cap rate, and make a smart decision based on numbers.

Remember, you do not need to make this decision on your own. Work with a Realtor who works with investors. They have most, if not all, the data you need.

Related: A beginner’s guide to buying a rental

How do I use cap rate to know when to sell an investment property?

According to the Financial Samurai, landlords can use the cap rate to decide when it is time to sell an investment property. He recommends that if this rate is below what you can earn in a risk-free 10-year Treasury bond with zero effort, it’s time to consider selling. As of January 10, 2018, the 10-year Treasury bond rate was 2.55%. If your cap rate is below that number, consider selling. Currently, the worst average cap rate is in San Francisco at 2.8%, which is still in the “keep your investment” range.  However, depending on your property’s maintenance needs, taxes, and loan interest rate, it is still possible to reach the 2.55% or lower cap rate.

Related: Tenants’ rights when selling an occupied rental property

There are a number of factors to consider when answering the “should I sell” question, but cap rate is one factor to consider.  Other factors are the following:

Whether you are a seasoned investor or a newbie, using a simple equation like the cap rate makes tough investment decisions easier. Now, if only there was an equation to help me make a decision on my car dilemma.

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