It is important to compare and calculate the cap rates for similar investment properties. Comparing the cap rates of similar properties can help you decide which property is a better fit for your portfolio.
The cap rate of potential investments can help you determine if the asking price seems reasonable. If it is too high based on your cap rates calculations, you may be able negotiate a lower price.
A higher cap rate is a must when you are looking to purchase an investment property. A higher cap rate will result in a better annual return. You should aim to earn at least a certain amount of income from your investment each year. To determine the price that you are willing to pay for a property, divide your net income by your target rate.
The cap rate assumes that you are paying cash for the property and not taking out a loan. It doesn't include any mortgage costs, such as interest and points paid. It doesn't include closing costs or broker's fees.
Real estate investors often include a 5--10% expected loss of rent in their calculations. Assume a 90% occupancy rate in the above example.
If you plan to sell the property, rent it out as a vacation rental or flip it, it is not necessary to calculate the cap rate. You want to keep the property for as little time as possible when you flip it. This makes the 12-month reference period of the cap rate less relevant. You will likely experience fluctuations in income and occupancy for vacation rentals or short-term rentals. Operating expenses may also fluctuate due seasonal maintenance or repairs caused by high tenant turnover. All these factors can affect your net operating income which, in turn, results in a unreliable cap-rate calculation.
When assessing property you expect to generate regular, predictable income, the cap rate can be a useful metric. You might calculate the cap rate of a 4-unit apartment block occupied by tenants on year-long leases.