Investment Property Basics: Calculating Cap Rate & Cash Flow
What is the Cap Rate?
The profitability of an investment property is calculated using the cap rate, and depending on the area, different cap rates may be considered to be favorable. You'll have a high cap rate if the acquisition price of the property is low in comparison to the projected rental income.
Cap rates in residential areas might reach 8–12%. Investors must monitor their properties because cap rates might fluctuate over time. They might decide to sell one property in favor of acquiring another. When maintenance, taxes, and other expenditures rise but rental rates in a given region do not the cap rate decreases.
How to Calculate Cap Rate:
Capitalization Rate = Net Operating Income / Current Market Value
You can use either the asking price or the price you'd offer as the current fair market value.
Example: You're thinking about paying $325,000 for a two-bedroom house. Currently, the rent is $2,000 per month. 12 (months) times $2,000 (monthly rent) equals $24,000 in gross rental revenue.
You estimate that your yearly operating costs will be $5,800, which will be made up of $2,000 in maintenance and other costs and $3,800 in property taxes.
Your anticipated net operating profit is $18,200 ($24,00 – 5,800).
The cap rate is then calculated by dividing your net operating income ($18,200/$325,000) by the property's current fair market value ($325,000 in this case).
If your calculations are accurate, this two-bedroom home would yield a 5.6% cap rate return.
Keep in mind that the cap rate assumes 100% occupancy and that rent is paid on time...
Cash Flow = total income - total expenses (pretty simple)
Cash flow in real estate refers to the amount of money that is still available after all capital expenditures have been paid. In other words, cash flow is the profit an investor can keep after all expenses have been covered. Investors frequently reinvest their cash flow to increase their liquidity, accelerate mortgage payments, or acquire more properties.
Therefore, the lifeblood of a real estate investing business is cash flow. To establish whether a property would do well, seasoned investors make a point of performing cash flow calculations. If the cash flow predictions fall below a predetermined level, they will almost always reject a possible property.
As to what exactly constitutes a "good" level of cash flow, there is no concrete definition. It is arbitrary, liable to change depending on the investor, and based on experience and the neighborhood rental market. Owners of rental properties should constantly ensure that there is sufficient cash flow to make the venture profitable.
The 1 percent rule is a useful general guideline. Investors in rental properties use this technique to assess a property's cash flow fast. The requirement states that the property's total rental revenue must equal at least 1% of the acquisition price. Anything below this standard ought to be disregarded.
The market has changed drastically from what we saw through the first half of 2022. Rates have doubled from the lows of 2020 and 2021. Properties are beginning to sit on the market longer as higher rates impact buyers.
Fewer buyers and higher rates means sellers are often willing to make price concessions to get a property sold. If you're thinking about investing in real estate and looking for a deal, chances are there's a property with positive cash flow nearby.