Most investors calculate cap rates similarly. The majority would agree that a cap rate is determined by taking the Net Operating Income (total rents collected less costs) / the Total All-in Cost (Purchase Price + Any Rehab costs).
Say the property has an NOI of $12,500, and the Total All-in Cost is $112,500.
$12,500 / $112,500 = 11.1% Cap Rate
Consider Appreciation & Equity
Many investors aim for cap rates in the 10-12% range on residential single-family properties. That’s all well and good to determine an asset’s viability, as a rental, in a flat market. When you are in a strong, rising real estate market, like Tampa Bay, appreciation/equity must also be considered when evaluating potential returns on investment assets. Taking into account the appreciation/equity gained annually, and adding it to the rental income will give the investor a truer look at cap rate.
Naturally, every investor wants the highest possible return on their money. The problem is that the best cap rates typically come from the lower-end neighborhoods that generally see the least amount of year-over-year appreciation. While the traditional cap rate is the highest, other assets can be far more lucrative over the long-term.
The Tampa real estate investing market has seen value increases of 10-15% per year and continues to grow. A 7% cap rate becomes a lot more attractive when you are also gaining 10% appreciation every year, all while rents continue to increase year-over-year as well. This equity should be added to NOI and the cap rate then determined.
Using the example with the above property, and assuming 5% (national average) appreciation, the adjusted cap rate would look more like this:
($12,500+5,625) = $18,125/$112,500= 16.1% Adjusted Cap Rate
I agree that the market won’t always gain 5% per year in appreciation. Worst case scenario, your basic cap rate will remain constant, and depending on the rental market, should increase proportionally to rent increases.
Cap Rate Examples of Three Rental Properties
Property 1-Lower-End Area – This illustrates typical rental return figures for a lower-end property with 3% year-year appreciation.
$70,000 (purchase) + $20,000 (rehab) = $90,000 All in Cost
Rents for $850/month (x) 12 months = $10,200 Gross Operating Income
$10,200/$90,000 = 11.33% Gross Cap Rate
Appreciation – 3% ($2,700)
$10,200 (Rental Income) + $2,700 (3%appreciaition) = $12,900/$90,000 = 14.33% Adjusted Cap Rate
Property 2-Mid-Range Area – This illustrates typical rental return figures for a lower-end property with 7.5% year-year appreciation.
$120,000 (purchase) + $25,000 (rehab) = $145,000 All in Cost
Rents for $1,150/month (x) 12 months = $13,800 Gross Operating Income
$13,800/$145,000 = 9.51% Gross Cap Rate
Appreciation – 7.5% ($10,875)
$13,800 (Rental Income) + $14,500 (10%appreciation) = $24,675/$145,000 = 17.01% Adjusted Cap Rate
Property 3-Higher-End Area – This illustrates typical rental return figures for a higher-end property with 10% year-year appreciation.
$150,000 (purchase) + $25,000 (rehab) = $175,000 All in Cost
Rents for $1,350/month (x) 12 months = $16,200 Gross Operating Income
$16,200/$145,000 = 9.25% Gross Cap Rate
Appreciation – 10% ($17,500)
$16,200 (Rental Income) + $17,500 (10%appreciation) = $33,700/$175,000 = 19.25% Adjusted Cap Rate
In short, considering appreciation/equity when evaluating a potential investment property is the only way to truly see the value it can bring to your portfolio. The base cap rate is the very least you will generate in return if the market is flat. Any appreciation/equity gained, will theoretically be added to your overall investment returns.
Graystone Investment Group
Graystone Investment Group is an experienced real estate wholesaler in Tampa Bay. We serve clients who flip homes in as little as 30 days, as well as clients who hold high cash flowing rental properties.
Unlike other wholesaling groups, we provide clients with a turnkey process at no extra charge. We find properties that we resell to investors at discount prices, while also connecting them with private financing. We also coordinate with rehab and management companies we’ve worked with for years.