Rental property course · Lesson 1 of 6
The cap rate is the return before the mortgage.
Before you look at the loan or the taxes, find what the property earns by itself. Two figures do this: net operating income and the cap rate.
Example House
| Assumption | Value |
|---|---|
| Price | $300,000 |
| Rent a month, year 1 | $2,400 |
| Vacancy and unpaid rent | 5% |
| Property tax, share of price | 1.0% |
| Insurance, year 1 | $1,800 |
| Repairs and upkeep, share of price | 1.0% |
| Property manager, share of rent collected | 8% |
| Yearly growth of rent and costs | 3% |
Example House is a made-up single-family rental. All six lessons use it. Change the assumptions to the real figures of a property, and the method stays the same.
Net operating income
| Year 1 | $ |
|---|---|
| Full rent | 28,800 |
| Vacancy and unpaid rent | (1,440) |
| Rent collected | 27,360 |
| Property tax | (3,000) |
| Insurance | (1,800) |
| Repairs and upkeep | (3,000) |
| Property manager | (2,189) |
| Operating expenses | (9,989) |
| Net operating income (NOI) | 17,371 |
Net operating income, or NOI, is the rent that you collect less the costs to run the property. Example House has NOI of $17,371 in year 1.
NOI leaves out three items on purpose: the mortgage, depreciation and income tax. These depend on the owner, not on the property. Lessons 2 and 4 add them back.
The cap rate
The cap rate is NOI divided by the price. For Example House, $17,371 divided by $300,000 is 5.79%. It is the cash return that a buyer with no loan gets in year 1, before income tax.
Use the cap rate to compare properties with one another, and to compare a property with the cost of a loan. Lesson 2 makes that comparison.
Rules of thumb
Some investors use the 1% rule: the monthly rent must be at least 1% of the price. Example House has rent of 0.80% of the price, so it fails the rule. Its NOI is still positive.
Some investors also assume that expenses take half of the rent. Example House’s operating expenses take 34.7% of the full rent. A rule of thumb can help you sort many listings fast. It cannot replace the real tax bill, the insurance quote and the cost of repairs.
Key points
- NOI is rent collected less operating expenses. It leaves out the loan, depreciation and income tax.
- The cap rate is NOI divided by the price.
- Use the real costs of the property, not a rule of thumb.