Residential Real Estate: Cap Rates Explained
What is a cap rate? Whenever searching for an investment such as a stock, currency, commodity, real estate, or any other type of investment, typically an important factor is what is my return on investment? If you’re new to the real estate game or trying to learn more you probably have not heard of a cap rate or have, but don’t quite understand what it means. This article will discuss what a cap rate is and what a bad cap rate is and what a good cap rate is.
To start, simply put, a cap rate is just a return on investment. It applies to any real estate investment you may be considering and the cap rate will help you determine if the investment is worthwhile. In order to calculate the cap rate you must take the net operating income and divide it by the price you pay for the property, and then multiply it by one hundred. That will give you the percentage of return for the investment property.
The next question, how do I know what a good return is? Well, the answer to that question is it depends on certain variables. The most important concern for any deal should be that the return is greater than the interest rate of your mortgage. For example, if you have a property that has an 8% cap rate and you are looking at mortgages for the property. It is best to have a mortgage below 8%, ideally the lower the better of course. The reason for this is that if the interest rate exceeds the return, then you are essentially paying for every percentage point past your return on that mortgage. It means you lose money, typically a lot.
Thus, it is best to always have a return that is much higher than the interest, not always possible, but best to aim for it. You probably now can figure out what a bad cap rate is based on what I have just discussed, but I would like to add one thing in regards to what is a bad cap rate. We now have established what a good cap rate is and what a bad cap rate is. This does not mean go and buy any investment property that is less than the return. You must make sure that there is a reasonable safety net, for example an interest rate of 5.8% and a return of 8%.
In the real estate business you must realize there is a possibility of vacancies, there are unexpected costs, and more. If any of your costs end up exceeding expectations or you have a vacancy, the property will quickly result in a negative cash flow. Thus, you will be spending money to keep your property a float.
In some cases it may be best to work with a partner so there is more cash involved in the deal to reduce risk of losing money in a deal. If you want to find an investor click where to find investors.