When investing in cash flow or rental properties it is important to understand what your return on investment is going to be. Investors refer to this as a CAP rate. Investors will target a specific CAP rate to make sure the properties they are buying are going to give them the desired return they are targeting. We will go through numbers to show you how your offer amount will be able to give you your desired CAP rate.
CAP rate is defined by Net Operating Income (NOI) divided by the cost of the asset. I’ll call the cost of the asset the all-in cost, which may include rehab costs as well. To get the NOI, I have to know the amount I can rent the property for minus all the expenses associated with owning that property. Let’s go through some numbers to show you how to calculate CAP rate.
Let’s say I need an 8% CAP rate to buy a rental property. The property will also need 15K worth of work to make it rent ready. Once it is fixed up, the property will rent for $1,100 per month. Taxes and insurance will cost me $150 per month. This is information I will need to get my numbers dialed in.
First, let’s get our NOI. We are getting $1,100 monthly for rent but we have to take off the monthly expenses.
- $1,100 – $150 (taxes and insurance) = $950
- $950 – $110 (10 % property management company) = $840
- $840 – $110 (5% for maintenance and 5% for vacancy) = $730
- $730 * 12 = $8,760 (Yearly NOI)
Now we have our NOI. Here is the rest of the calculations to get our offer amount:
- $8,760 / .08 (desired CAP rate) = $109,500
- $109,500 – $15,000 (rehab cost) = $94,500
- $94,500 – $2,835 (3% closing costs) = $91,665
This formula has given me an MAO (maximum allowable offer) of $91,665. This offer will give me an 8% CAP rate. Now, if we go one step further and want to wholesale this to an investor that wants an 8% CAP rate, we only have to subtract our assignment fee.
- $91,665 – $3,000 (assignment fee) = $88,665 (MAO for an assignment)
By using this formula you should be able to calculate whatever CAP rate you or your investors are hoping to get from a rental property.