If you’re new to the world of real estate investing, you might find some of the terms that you encounter somewhat confusing and even intimidating.
However, the more you know, the better your chances of success.
You need to know how to analyze your profitability, for example. And, to do that you’ll have to understand cap rate and cash flow, and how those terms can help you understand how your real estate investment is performing.
These terms are fundamental to the real estate investment world, and understanding what they mean is essential for any investor. If you’ve seen them tossed about, but you haven’t been sure how to ask what they mean, we’re here to help you with that. Let’s de-mystify the concept of cap rate and cash flow so that you can make informed investment decisions.
CAP Rate and Your Rental Property
Cap rate is short for capitalization rate. It refers to the percentage that represents the expected annual rate of return of a property, assuming that it was acquired through cash investment, or not financed by a loan. Cap rate is calculated in a simple formula which is the annual net operating income (NOI) divided by the property value.
First, you’ll need to calculate your NOI, and luckily, that’s a simple formula. You’re calculating your income minus expenses over the course of a year. These expenses exclude your debt service.
It’s simple math, but it has to be accurate math. Everything else depends on it. So, take a look at what’s coming in (rental income) and what’s going out:
- Insurance premiums
- Property taxes
- Repairs and maintenance
- Management costs
- Advertising and marketing costs
- Services like pest control and landscaping
All of your costs will be deducted from your income, apart from the mortgage you pay. There are likely to be vacancies from time to time, so make sure you include that in your calculations. This is the difference between Potential Gross Income (PGI) and Effective Gross Income (EGI).
Be careful with your deductions for repairs and maintenance. You don’t want to under-estimate what you’ll spend on labor, materials, and supplies. Inflation has pushed up the cost of maintenance. Make sure your NOI calculations reflect that.
Once you have your NOI calculated, you can determine your cap rate. That formula is a bit more complex. You’ll divide your NOI by your purchase price, which is converted to a percentage. This is how you compare yields of different properties. If your NOI is 10 percent and you purchase a property for $100,000, your cap rate is 10 percent.
For example, a real estate property that generates a $20,000 NOI every year and has a value of $200,000 has a cap rate of 10% ($20,000/$200,000). When considering an investment property, investors should aim for a good cap rate which means a high cap rate. However, a high cap rate does not necessarily indicate that a property is a good investment. Other factors such as the location, potential for appreciation, and competition in the marketplace should also be considered.
Understanding Cash Flow
Cash flow refers to the amount of money left over after all operating expenses, mortgage payments, and taxes have been paid. In real estate investment, cash flow is a critical factor because it helps investors determine the profitability of their investment. A positive cash flow means that there is more money coming in than going out, while a negative cash flow means that more money is going out than coming in.
For instance, if a rental property generates $3,500 in monthly rent, and the total monthly expenses for the property including mortgage payment, maintenance, and taxes, is $3,200, the monthly cash flow is $300. A positive cash flow means that the investor can use this money to reinvest in the property or for other investment opportunities.
What You Need to Know about Cap Rate and Cash Flow
Cap rate and cash flow are essential to understanding the potential return on investment for a real estate property. They help investors evaluate the rate of return, the potential appreciation of the property, and the cash flow. A good investment property should generate high cap rates and positive cash flow.
But, there are a few things to consider:
- You’re probably not going to earn that 10 percent cap rate that you’d like. In the current Bay Area real estate market, most investors have been buying investment properties with a much lower cap rate, but they’re feeling pretty comfortable because they know that their investment is earning good money.
- Remember that cap rates are also likely to improve as prices adjust lower. We’ve had some skyrocketing prices in the market over the last couple of years. As those prices start to peak and settle, you’ll see that the cap rate improves. However, there’s also inflation to contend with. Your cash flow may be impacted by rising prices and other financial squeezes.
When you’re evaluating potential investment properties, you don’t want to use only the cap rate to decide whether it’s the right property for you. Think about your own investment goals and talk to a local property manager so you can get an idea of what the location of the property is like, what type of tenants might be interested in renting the home, and what you can expect in terms of your investment experience.
Understanding cap rates and cash flow is essential for any real estate investor. These two concepts are critical factors in evaluating the profitability of an investment property and making informed investment decisions. A good investment will generate high cap rates and positive cash flow, but investors should also consider other factors when evaluating investment properties. By considering all relevant factors, investors can make an informed and profitable decision, leading to success in the world of real estate investment.
Thinking about how to invest wisely? Whether you’re just starting out as an investor or you’re building an impressive portfolio of rental properties, we can help you make some good and profitable decisions. Contact us at California Pacific Realty.
