Buying a rental property often seems like a great idea. Who wouldn't want an opportunity to make passive income?? (income you don't earn through labour) But, there's so much more to it than just looking at a place and thinking "Hey, that looks like a great opportunity, I'm gonna buy it!"
Before I started as a Realtor® I'd never even heard the term "Cap Rate" or capitalization rate. But now it's a major part of my day to day and I want to make sure y'all know what it is and why it's so important.
Essentially the CAP rate is a way to determine if a real estate investment is worth the money. It's the ROI (return on investment) on any property you look at as a potential revenue generator.
In the Lower Mainland it's really easy to think "I'll buy this and it will go up in value and I'll make money on it.". While that may often be true it's only one small part of the picture of investing in property and it's not the most important part.
Arguably CAP rate is a whole lot more important that speculation (thinking that the property will increase in value over the time you own it)
To calculate the CAP rate you divide the property's Net Operating Income (NOI) by its current market value or purchase price.
CAP Rate = (Net Operating Income / Property Value) * 100
Net Operating Income (NOI) is the property's potential income from rent and other sources, minus operating expenses such as property taxes, insurance, maintenance, and property management fees.
Net operating income is $90,000. (all rents less all expenses)
Property value/cost is $3,998,900
CAP Rate = $90,000/$3,998,900 *100
In this example the CAP rate is 2.25%.
What does that mean?
In Canada a "good" cap rate is between 4% and 12% with a higher rate coming with more risk. (more risk/more reward)
Why do we use CAP rates? We use this to compare properties where other factors are equal. For example, 2 condos in 2 buildings that are very similar and yield the same rental income but have different prices. One will have a better CAP rate but you have to also consider other factors when determining if that one is best for you.
The CAP rate does not take into account any financial factors like mortgage rates etc. Which means that someone paying "cash" for a property, without having to pay to use the money, is going to make more on the investment than someone who has to borrow money to do so.
CAP rates are used as a quick way to compare properties and determine whether or not the investment is sound. In the example above the CAP rate is only 2.25%. Not great.
Would you buy it?
If you want to learn more, and there is a lot more to learn, give me a call or email and we can chat about it. I'm always happy to lead you through any of the processes that make our real estate market a ton of fun ;)