How to calculate the cap rate for a rental property
What is a cap rate?
The capitalization rate, or cap rate, is the estimated rate of return on an investment property without factoring in loan expenses. It looks at the purchase price of the home rather than the actual cash you may have invested to buy it (e.g. a down payment + closing on a loan). Back to my example above, we can calculate cap rate as follows:
Below we'll walk through how to calculate cap rate for a rental property, walking you through an example scenario.
How to calculate a cap rate for a rental property
Cap rate = Annual NOI / purchase price of home*
*Where the purchase price includes any repairs / renovations necessary for occupancy
So, suppose we purchase a home for $100,000, and spend an additional $15,000 in closing costs + minor rehab prior to occupancy for a total cost of $115,000. Additionally, suppose the rental returns a net operating income rent - your monthly expenses of $909.62. Here we would have a cap rate of:
($909.62 * 12) / ($115,000) = 9.5%
What is considered a good cap rate for a rental property?
Generally, a cap rate of 8-12% is considered 'good', though a variety of other factors (such as your monthly cash flow, expected appreciation, etc) will play into this. Additionally, keep in mind that cap rates rely on net operating income and assume that no loan is taken out to fund the property which is not necessarily the best strategic move when building a portfolio of rentals. This is where other metrics like cash-on-cash return can come into play. You can read more about cash-on-cash and other rental ROI metrics here.