02 Nov Quick and Easy CAP Rates
You may hear the term CAP Rate (CAP Rate = NOI ÷ Price) from time to time, especially when evaluating rental properties for sale. You may already know what it is, why it’s important and how to calculate it. But, do you know how to estimate a CAP rate in less than 10 seconds? If not, here’s a quick tip for estimating CAP rates that may save you a lot of time when sizing up your next potential investment property.
One of the more time consuming tasks when evaluating a properties CAP rate is determining the net operating income (NOI) or total income minus total expenses (excluding debt service). The rental income estimate is usually easy enough assuming you follow the market but what about those expenses? The only true way to determine the properties NOI is by detailing each line item expense, including taxes and subtracting for vacancy; otherwise known as a Proforma. Though time consuming, these proformas offer the most accurate financial picture of a properties net income.
However, if you’ve done enough of theses proformas, sooner or later you’ll notice a pattern. Most residential investment property expenses, taxes and vacancies account for ⅓ of their income, on average. The bulk of them coming in between 31-35%. So to quickly estimate the NOI, all you would have to do is subtract four months of annual income or multiply eight months of rental revenue. For example, a single family home renting for $1,000/mo should have a Net Operating Income (NOI) close to $8,000 ($1,000 x 8 months).
Now that we havea quick and easy way to estimate the NOI, calculating a properties CAP rate is a snap. Remember that the NOI ÷ Price = CAP Rate. So if a single family home rents for $1,000/mo and is selling for $120,000, the CAP Rate would be 6.7% ($8,000 ÷ $120,000). How about a fourplex collecting $2,200/mo going for $220,000? It would have an 8% CAP Rate ($17,600 ÷ $220,000).
Of course, nothing substitutes the accuracy of a CAP Rate that comes from a real proforma, but before investing the time and due diligence, check it out with a Quick CAP rate and see if it’s worth your time. Having a quick and easy way to identify a good investment property will help you find the right deal even faster. And as with any good deal, they usually don’t last long.