If you have ever thought about investing in a rental property but are unsure if it made financial sense this article is for you!
Buying a rental property is very different from buying your personal home, in that a rental property in a financial investment and it must generate a reasonable return on your investment in order to be worthwhile. So how do you know if buying a rental property is worthwhile? Keep reading to find out…
As a real estate investor you must analysis properties from a finance perspective… A very important finance calculation is the C.A.P rate.
The Capitalization Rate (Cap rate) is a mathematical expression how much monetary return you will receive on your investment. In other words the percentage return an investor would receive on an all cash purchase.
The Formula is:
Essentially to determine the capitalization rate you take the net annual operating income(NOI) and divide it by the purchase price of the property. However before we can determine the cap rate of a property you must determine the annual net operating income.
Annual Net Operating Income
The calculation for determining the annual net operating income:
So to calculate NOI you would take the gross operating income (annual projected rent) and subtract all the operating expenses. Operating expenses would include thing such as:
-repairs and maintance
-Property Management (if applicable)
However, it is important to note a few expenses are not part of the NOI, these include income tax on profit and mortgage interest.
CAP Rate Example
To demonstrate how to use cap rate here is a fictional example…
$510,000 Basement Home in Walnut Grove, 2400sqft with double garage, This home has a projected monthly income of $2,500/mo.
2,500 x 12 = $30,000 (Annual Gross Rental Revenue)
Operating Expenses are:
$2,500 /yr insurance +
$3,600/ yr Repairs, +
$3,600 / yr Property Taxes
Total Operating Expenses = $9,700
Using the above formula we can calculate NOI to be $20,300
From this we can use the formula determine the cap rate…
20,300/510,000 = 3.98% So the capitalization rate of this particular (fictional) home would be 3.98%
From this we can also determine the payback period as follows…
510,000 / 20,300 = 25.1 Years or 301.5 months.
The Payback period refers to how long it will take to recover your investment through collecting net income genrated by the property..
Now, of course our example assumes that an investor plans to hold the rental property indefinably, but in reality many investors do sell properties at some point in which case they may also realize a profit when they sell their property especially if they have held it for many years. Any gains in property value made at the time of selling would usually be subject to capital gains taxation, just as most other investments would be...
Uses of Cap Rate:
- Cap rate can be used to determine the fair value of a rental property compared to other properties in a similar area.
- Cap Rate can be used to decide between investments types eg.( Real Estate v.s bonds)
- Cap Rate can also indicate risk, for example properties in one area of a city may have a higher cap rate because there is less demand for rentals in the area so they carry a higher risk of vacany. Some other examples of risk that can affect cap rate are, age of a property, credit worthiness of current tenants (if applicable), length of lease in Place (if applicable), etc…
- Cap rate can also be s sign of how much demand there is in the market for a certain type of property, meaning if a trend of cap rate decreasing for a certain type of property is observed, the market for this type of property is heating up and prices are being bid up thus reducing the cap rate.
What About Vacancy?
Vacancy is an important consideration for potential investors. And on the long term vacancy does effect cap rate. However the expected vacancy rate can vary significantly based on the area type of property etc…
Example: If in the area a 2 week per year vacancy was expected you would deduct half a months rent from the Gross Rental Revenue.
For the example we discussed above this would reduce the Gross Rental Revenue to $28,750 (from $30,000) and the NOI to $19,050 (from $20,300) resulting in a C.A.P rate of 3.74% and a 26,8 Year (or 321.3 months) Payback period.
Thus projected vacancy is an important factor to consider when calculating cap rate, but the projected vacancy rate will vary based on area and the type of property.
What about Mortgage/Financing Costs?
Mortgage payments are generally not included in the calculation of C.A.P rate. The reason for this is that financing costs from leveraging can very significantly based on credit history as well as down-payment etc.. which would result in a skewed CAP rate if they were included.
However interest expenses on mortgages of investment properties are usually tax deductible so using a mortgage (leveraging) when investing in real estate can have tax benefits, talking with an accountant would be advisable if you are considering using leveraging (a mortgage) when purchasing a rental property as a way to reduce tax on the revenue.
Although it is not included in CAP rate calculations, financing is a very important aspect in determining if a rental property will make sense financially. Speaking with a good mortgage broker about you ability to finance the purchase and the interest rate avaible is advisable. If you are thinking of buying a rental property using a mortgage and you are not currently working with a Broker please contact us and we can direct you to good mortgage broker who can disscuss what financing options are avalible to you.
As a current or potential real estate investor, Capitalization rate and other financial considerations are key to making sure that you receive a good return on your investments, which is why we have written this article as a service to our current and future clients, that will help them better understand the finance apect of investing in real estate rental properties.
This article should be considered as a good introduction to some of the useful finance concepts that can be used when deciding to invest in rental properties.
This article is however, not intended to be a comprehensive guide to the finance side of real estate investing.
If you are thinking of investing in rental properties in B.C’s lower-mainland as part of your investment portfolio please contact us we would be happy to discuss some of the finance concepts you should consider when investing as well as assist you with finding a property that would suite your investment goals. We can be reached through this website or by phone at 604-882-8384.
Doug, Bonnie and David Mitten (Mitten Real Estate Team)