To compare the profitability of investment properties, whether they are single family homes, multifamily houses, large apartment buildings or luxury high-rise condos, real estate investors developed a formula. This formula is known as “cap rate” (officially it’s “capacity rate”), and it is arguably the most important measurement of how much a property returns on its investment

Calculating a property’s cap rates is the industry standard for estimating its potential rate of return, and is equivalent to the net operating income (NOI). It is an estimate of cash flow income and, if an acquisition was made in cash, it is the return on investment (ROI). If an investor financed their purchase, those monthly mortgage payments need to be factored in to calculate the ROI.

The basic formula: Capitalization Rate = Net Operating Income / Current Market Value (Purchase Price)

However, there are other costs to take into account when calculating a property’s true cap rate. These are steps to do that.

1. Calculate the gross annual income. This is the rental payments, plus any other income-producing business associated with a property.

2. Subtract 10 percent of the total annual rental income to account for a potential vacancy.

3. Subtract ALL operating costs for the rental: management costs, taxes, utilities, insurance and any other expenses such as maintenance, to determine Net Operating Income (NOI).

4. Next, divide the NOI by the acquisition cost for the property, including brokerage fee, closing costs, and all the renovation costs necessary to make it “rent ready.” The result will be the cap rate, expressed as a percentage.

5. The cap rate will change in year two once the one-time closing costs are no longer factored. But annual maintenance will need to be factored in, which will average approximately 1.5 times the monthly rental rate, the so-called 5x rule. For instance, home renting for $1,200 a month will cost about $1,800 a year to maintain.

6. The formula assumes that acquisitions are all cash and do not involve finance charges. If a purchase is financed, those interest and principal payments need to be added to operating expenses. This will determine the return on investment (ROI).

The relationships between rents, operating costs and acquisition costs are intertwined. If a property costs more, it will need to fetch a higher rent to achieve a cap rate associated with cheaper properties in the same neighborhood. To calculate rental property returns and income taxes, Mynd offers a table that lets an investor plug in the numbers for a particular home and get results that can help them decide if an investment makes sense.

To calculate rental property returns and income taxes, Mynd offers a table that lets an investor plug in the numbers for a particular home and get results that can help them decide if an investment makes sense.

Calculating real estate cap rates allows investors to compare properties in different areas by employing the same criteria to estimate their return on investment. It also emphasizes the importance of controlling operating costs. Unnecessary operating costs will lower rental returns, but if those expenses can be controlled, cap rate and profits rise.

When using a real estate cap rate calculator, be sure to check that all costs are included and that a consistent formula is applied. For example, some calculations fail to take into account vacancies, which are inevitable in the rental market.

What constitutes a good cap rate depends on investment goals, and can vary from region to region in the country. Some strive for a cap rate as high as 10 percent, but in a competitive market that is more difficult to achieve, and properties with these rates of return are often in less desirable neighborhoods, which pose higher risks. These days, a cap rate of 5-6 percent for single-family rentals in many hot markets is a more reasonable expectation. Some investors believe that properties that have a 7-8 percent cap rate offer a good balance of risk and stability.

In general, higher cap rates have a higher upside, but there are usually pitfalls associated with them, including purchases in areas where turnover is higher, tenants who rely on government subsidies, amenities are scarce, and quality of life issues like crime are an issue. Lower cap rates are to be expected in more stable neighborhoods, where returns are likely to be more predictable, but investors can look for greater appreciation on the value of a property.

But measuring the cap rate does not tell an investor all that needs to be taken into account, because it does not factor in leverage, the possibility that a property will increase in value, the time value of money, and future cash flows from property improvements and other factors.

Tere are benefits associated with single-family rental homes that can ease the tax burden. Among the expenses that can be deducted are:

· Cleaning and maintenance

· Mortgage interest

· Insurance costs

· Marketing budget for a property

· Property management fees

· Fees charged by a condo or homeowners association (HOA)

· Property taxes

· Services the investor pays for (gas, gutter cleaning, etc)

· Professional fees associated with income property, such as legal expenses or budget keeping.

Mynd has a primer on the 20 percent Qualified Business Deduction, one of the hidden tax benefits related to rental property ownership. And Mynd has a complete list of 31 tax deductions that are available to landlords that are often overlooked.

To avoid paying capital gains taxes when it comes time to sell a property, a seller can execute a 1031 exchange, which shields the profits from the sale of a property if it is used to buy another property of equal or greater value. But there is a time limit of 180 days for the purchase of a new property, which can put pressure on a buyer to accept a less desirable deal.

There’s yet another tax break for rental property owners known as the Qualified Business Income (QBI) deduction, which allows deductions of up to 20% off taxable rental income. The QBI has a threshold of $315,00 for married taxpayers and $157,000 for everyone else. Any income that falls below the threshold is allowed the full 20% deduction. Those who make more than the threshold can still get the deduction, but it’s a new and complicated deduction so a tax professional should offer guidance.

Rental property provides an investor with several potential passive income streams. Rent is collected monthly; an investment property appreciates over time; equity in a home accrues over time, which can be used to get a low-interest loan; and a property may sell for a higher price than what was paid for it.

Before investing in a rental property, consider the demands of being a property manager, which require time and labor. Interacting with tenants, answering emergency calls, and dealing with vacancies can be stressful. Some responsibilities will include:

Tenant Management — Finding tenants, screening tenants, drawing up legal lease contracts, collecting rents, and evicting tenants if necessary. · Property Maintenance — Repairs, upkeep, renovations, emergencies and more.
Administrative — Bookkeeping, setting rent, taxes, paying employees, budgeting, etc.

A property manager can handle these tasks, but they charge 4-12 percent of the gross rents, which can be a lot if there is only one property in a portfolio. Or the individual investor can contract with Mynd to do the work since it offers all the services of a traditional property manager at a lower cost by leveraging technology and artificial intelligence.

There are various ways to calculate a property’s value using rental income, but there are two quick and easy ways to estimate potential net income:

· 50% Rule: This estimates that expenses will eat up half of gross income. The other 50 percent can be used to pay off a mortgage, and what’s left over will be net operating income. This method gives a rough idea of income stream and potential profit.

· 1% Rule: Gross monthly rental income, meaning the amount an individual makes before taxes, should be at least 1% of a property purchase price, after repairs.