Understanding a Good Cap Rate

Understanding a Good Cap Rate

You may have an understanding that real estate is a solid investment choice. There are a lot of advantages and opportunities in the marketplace right now. You may even be at the point where you have started looking.

But once you find an investment property, how do you know if it is worth pursuing? Will the property be a good investment for you?

If you don’t evaluate your investment return, you could find yourself with a property that doesn’t do anything for you. One of the easiest ways to evaluate an investment property is to calculate the cap rate.

What Is Cap Rate?

Cap Rate, or capitalization rate, is a simple calculation you can use in evaluating a rental property. If you are looking at several properties, calculate the cap rate for each. For example, if you’re looking at two similar properties, compare the cap rate for each to determine the better investment.

There are a lot of metrics out there. But cap rate is an industry-standard and an easy way to review the investment property. Cap rate can also help you determine if the asking price for the property is reasonable.

Of course, cap rate is not 100% accurate. Many factors can impact your return on an investment property, such as vacancy or a huge change in market conditions. You’ll want to think about the potential risks and the impact on your cap rate.

How to Calculate a Cap Rate

The cap rate formula is straightforward. It is calculated in the following way:

(Net Operating Income / Current Market Value) x 100 = Cap Rate

So, for example, if you have Net Operating Income (NOI) of $14,000 and the value of the property is $225,000, you’ll have a cap rate of 6.2%.

Your Net Operating Income is your total revenue for the property, less your total expenses. Your income will mostly be the rents from the property but could include other income. The expenses will be anything that you need to pay related to the property, from maintenance to taxes to insurance.

A “good cap rate” is generally considered to be anywhere from 4 – 10%. If the cap rate for the property you are considering is below 4%, you will want to think about whether that property is a good investment.

Also, think about the factors that may impact your cap rate on an annual basis. Since cap rate looks at the value of the property, what happens if the property value changes? Or what happens if the expenses of the property increase, impacting your NOI?

The type of lease you enter into with the tenants will also impact your cap rate. If you are buying a property with existing tenants, ask about any existing leases, and understand what the impact of that lease will be on your cap rate.

Types of Leases

The type of lease you have with tenants will impact your cap rate. The lease will drive your overall expenses for the property, which is a factor of NOI.

Understanding the cap rate of the property requires that you know the expenses. Also, know that changing the lease type for the existing tenants could make the relationship rocky or end up with tenants leaving.

Since NOI is based on your income less expenses, you need to have a good handle on both. Think also about variations in expenses from year to year. Are any of the expenses expected to increase, and are you able to increase the rent without risking your tenants?

Different leases have different impacts on your NOI, so it is important to understand each.

Triple Net Lease (NNN)

In a triple net lease (NNN), your tenants will pay all expenses of the property. This can include real estate taxes, insurance, and insurance. If your rental space is an office building, this would also include janitorial or other maintenance services.

In a NNN lease, your rental income is usually lower. However, any increases in expenses are the responsibility of the tenant. This makes it easier for you to calculate cap rate year-over-year because you don’t have to factor in increased expenses.

The benefit to the tenant is the lower price point on the rent itself. If the property includes office space for multiple tenants, they can share the janitorial or other maintenance expenses.

Full Gross

In a full gross lease, the rent includes all of the expenses. The landlord pays taxes, insurance, and maintenance. 

In a gross lease, the rent is higher because the anticipated expenses have to be covered. However, for the tenant, there is peace-of-mind in not incurring additional expenses each month. The payment each month is known and easy to budget.

As a landlord, you will enjoy a higher rent. However, you will need to factor the expenses into your cap rate and think about potential increases.

Modified Gross Leases

The gross lease tends to be more tenant-friendly, and the NNN lease tends to be more landlord-friendly. In the middle sits a modified gross lease. A modified gross lease is a compromise of the NNN lease and the full gross lease.

In a modified gross lease, the landlord pays some of the expenses, such as property taxes, insurance, and common area maintenance (also known as CAMS). But things like utilities are janitorial services are usually paid by the tenant.

Tenants and landlords can negotiate what expenses are covered by a modified gross lease. It can be any combination of expenses of the property.

Commercial vs. Residential 

Looking at cap rate is a bit different for commercial versus residential rental properties. Most tenants for residential properties expect a full gross lease, where the landlord pays all of the expenses.

For you, as a residential investment property owner, the cap right might be less meaningful depending on how you plan to use the property. You may be planning to flip the property or rent it out on a short-term basis (like an Airbnb). These factors make the traditional cap rate calculation less meaningful.

Calculate a Good Cap Rate

When you are looking at purchasing a rental property, you will want to calculate as much information as possible related to the income and expenses. Then think about how your expenses may change over time, as well as any increase in rents.

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