A good way to analyze rental property is called a cap rate. The capital rate is a great tool to use to help you profit more from your rental property. The formula for a cap rate is the net operating income divided by the purchase price. This purchase price also includes any expenses that are for upfront repairs. This rate can be used when analyzing one specific property, but it can also be used on an overall grouping of properties as well. Net Operating Income includes Gross Rental Income minus property insurance and property taxes as well as common utilities, Vacancy/Credit Loss return, maintenance repairs, and other expenses. The focus of this type of formula is to look at the property alone and not how it was financed. This formula lets you look at the positives about a property without taking any of the debt into account. Because a cap rate measures risk, the higher the rate, then the higher the risk. The lower the rate means the lower the level of risk.
There are three different factors that actually affect the cap rate. Demographics and Macro-level economics have an effect on the cap rate. Places that have a higher population and less construction show there might be a bigger demand for rental properties. Therefore they would have a lower cap rate. Those areas that are more rural and probably do not have as big a rental demand, would have a higher cap rate.
Micro-Level markets can also affect the cap rate. Buildings in real estate are classified into four different groups, A, B, C and D. A property with a Class A rating would be the newest and most desirable building in the best location. Then the properties get classified into progressively less sought after characteristic, with Class D being the least desirable. Obviously, Class A properties would hold the least amount of risk, where Class D would have the highest.
The type of property that you have can also affect the cap rate. Commercial real estate would hold greater risk than residential property. This is because, during a recession, people still need to live somewhere. They may not be able to finance a business during that time, which would mean the commercial property would have a greater risk.
When investing in real estate, a cap rate will allow you to decide if you want to sell an already existing property. It can help pick a market or type of property to invest in and it can also allow you to set goals to determine how your acquisitions are going to perform.
This article was originally published on JasonCohenPittsburgh.org
Jason Cohen (Pittsburgh) 