How to Find the Capitalization Rate for Rental Real Estate

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November 2, 2022

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Rental properties are perhaps the most common way real estate investors generate steady income and boost their investment portfolios. Capitalization rate is a major metric used to determine the profitability of any commercial property. So, here’s how to find the capitalization rate for rental real estate.

How to Find the Capitalization Rate for Rental Real Estate

The formula for determining the capitalization rate of a rental property is Capitalization Rate = Net Operating Income (NOI) / Current Market Value—where the net operating income is the expected yearly income yielded by the property, subtracting all the expenses incurred in the management of the property. These expenses include regular maintenance of the building, property taxes, and insurance.

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The current market value of a property is the present price of the property compared to the current market rates. Dividing the NOI by its current market price further portrays potential returns and risks associated with the rental property

To better understand how to calculate the capitalization rate, follow this step-by-step explanation:

  1. Calculate your net operating income by subtracting your total operating expenses, including vacancies, from your total rental income for the year
  2. Next, divide the figure gotten by the current market price of the property
  3. The resulting figure is in decimals which is then multiplied by 100 to get the rate of capitalization percentage.

Illustrations on How to Calculate the Rate of a Rental Property 

If you are interested in purchasing rental properties, here are a few hypothetical examples to help you understand how to determine the capitalization rate of a property and how to use them to compare and determine the profitability of different properties: 

Determining the Rate of a Single Property 

Assuming that the estimated annual rent received on a rental property is $180,000, the investor pays a total of $40,000 towards several maintenance expenses, insurance, and property taxes. After subtracting these expenses from the gross income, a net income of $140,000 is left. 

Also, assuming the property value remains constant at the initial purchase price of $2 million during the first year, the rate will be calculated as $140,000/$2 million = 0.07. Multiply 0.07 by 100; therefore, the rate of this property is 7%.

Comparing the Capitalization Rate of Different Properties

Here is another example comparing the capitalization rate of different properties. Let’s say property A is in the city center of Cincinnati while Property B is on the city’s outskirts. The estimated annual income of property A is $100,000, with its total maintenance expenses rounding up to $20,000. 

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  • After subtracting the expenses from the gross income, you are left with a net income of $80,000. Dividing the net income by the current property value of $800,000, the cap rate of property A would be 10% i.e ($80,000 / $800,000) x 100% =10%
  • On the other hand, property B has a net operating income of $40,000 and a current market value of $300,000. This brings the property’s cap rate to 13% i.e ($40,000 / $300,000) x 100% =13%

From the example shown above, it is evident that property A has a lower rate compared to property B, indicating that it has a higher rate of return and lower risk associated with it.

What Factors Affect the Cap Rate of Rental Real Estate in Northern Kentucky?

It is essential to understand that several conditions influence the capitalization rate of a rental property, and these conditions should be factored in when making important decisions on rental investment opportunities. Let’s take a look at some of them:

Location of the Property 

The area where a property is situated greatly determines its vacancy rate and the types of tenants it attracts. Typically, busy urban areas like Northern Kentucky tend to attract more tenants, who are also more likely to pay higher rents than tenants in rural areas would. 

This, in turn, increases the value and profitability of such investments. Also, due to the high demand for properties in urban areas, these properties tend to have lower risks. Therefore, a real estate investor is likely to generate a lower cap rate on a property in a market with high demand and low associated risks.

Property Type

The type and class of a property can also significantly impact its rate. For instance, a class A rental property would have a lower cap rate than a class C rental property or even single-family homes. 

This is because such high-class rental properties tend to attract more buyers, resulting in higher occupancy rates and longer leases. Hence, these types of properties yield steadier incomes due to multiple tenants, unlike the class C and D properties with lower occupancy rates or single-family units that depend on one income source.

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Real Estate Market Trends

The current state of the real estate market is also a factor that significantly influences the cap rates of rental properties. For instance, in a seller’s market, cap rates tend to be lower because of higher demand for property and buyers’ willingness to pay higher costs to acquire these properties. 

This, in turn, drives up the value of such properties. Similarly, in a buyer’s market, the cap rate for rental investment properties tends to be higher due to the low cost and availability of the property.

Related Questions

What Is a Good Cap Rate for Rental Property?

A good cap rate for multi-family or any rental property ranges between 4-10%. However, an investor needs to determine what a ‘safe’ cap rate is for them, depending on their risk assessment. Consequently, it is advisable not to solely base your decision on a single metric and to seek professional assistance before investing in a property.

This professional assistance includes hiring a reputable company like Si Vales Valeo Real Estate. These professionals will ensure you make only practical and profitable decisions as regards your investment. This is due to their vast knowledge of the Cincinnati market and marketing strategies, such as performing CRE analysis to help you achieve your investment goals.

What Is a Good Cap Rate for an Airbnb?

A cap rate of 8-12% is ideal to ensure that you make a decent return on your short-term rental property, even after all the operational expenses are deducted.

Conclusion

Capitalization rate is one of the commonly used metrics when evaluating the return potential of a property. This article provides information that will assist investors in understanding how to calculate capitalization rates and factor in the results in making the best decision concerning a rental investment.

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