What's the CAP Rate Formula? 4 Reasons Why I don't use CAP Rate When Analyzing Investment Properties

What is the CAP Rate Formula?

CAP rate, or capitalization rate, is one indicator that real estate investors use when analyzing the potential of an investment property. 

Here are the four steps in calculating the CAP rate.

Step One - Take the monthly rental income, multiplied by 12 to get your annual gross rental income.

Monthly Rental Income X 12 = Annual Gross Rental Income

Step Two - Add up all the operating expenses such as property taxes, insurance, maintenance  and multiply by 12 to get your total annual operating expenses for that specific rental property. Do not include the mortgage because the financing is really dependent on how much down payment the real estate investor is willing to put down, so take that out of the equation.

Operating Expenses X 12 = Total Annual Operating Expenses

Step Three - Subtract the net operating expenses from the total annual gross rental income and that will give you your net operating income. 

Total Annual Gross Rental Income - Net Operating Expenses = Net Operating Income

Step Four -  Take that net operating income and divide it by the purchase price or the listing price. That will give you the CAP rate for that specific property.

Net Operating Income / Purchase Price or Listing Price = CAP Rate

There are four reasons why I do not use CAP rate when looking at potential investment properties, especially in the residential space.

Here's reason number one, CAP rate is predominantly used on commercial properties and not residential investment properties.

Two, CAP rate does not tell you the full story. For example, you can buy a property with a high cap rate, 8% to 9% to 10%, but that property could require a lot of repairs, or a lot of work because it's been neglected over the years.

Three, you can buy a property with a high CAP rate in a town or a city that does not have strong capital appreciation. So although the CAP rate might look high, that specific city or town does not have a potential or strong potential to appreciate over time.

Four, I like to look at the potential of a property. I'll give you an example. If you look at a single family home, the CAP rate on that specific property will be very low because there's only one rental income coming in, but if that specific property has the potential to be duplex or triplex where you can add a second and a third unit, now you can triple that potential rental income. Instead of having one unit that's rented, you'll have up to three units that are rented, and that can significantly increase your gross rental income which will improve your CAP rate. Again, the CAP rate doesn't tell you the full potential of a specific property, it's only one indicator.

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