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Understand how capitalization rates (or cap rates) are calculated to identify the best methods for assessing a potential rental property investment.

Capitalization Rate: What It Is and How To Calculate It

The capitalization rate is one of many ways to evaluate a potential investment property. Still, it’s critical to understand how capitalization or cap rates are calculated and their limitations. With a better understanding of calculations like cap rates, you can identify the best methods for assessing a potential rental property. 

Capitalization rates compare and estimate the future return on investment or ROI of one or more real estate properties. Cap rates for residential and commercial real estate are expressed as a percentage. They’re a popular tool because they help individuals estimate the potential return on real estate investments. 

Capitalization rates measure the potential yield of a specific real estate property over one year, assuming that the property is not financed. You can also think of cap rates as the percentage rate of return, either a loss or gain, of a specific property based on the income it generates, minus expenses. 

How do you calculate the capitalization rate of a property? There are two methods or formulas that are used to calculate capitalization rates. 

Most real estate investors will use the calculation which divides the net operating income by the property’s current market value. This calculation can be expressed using this formula:

Capitalization Rate = Net Operating Income / Current Market Value

In this calculation, the net operating income equals the estimated annual income minus expenses like maintenance, property management, and property taxes. This formula is most popular because it compares the projected income of a property against the current market value. 

The second formula used to calculate capitalization rates differs because it compares net operating income against the property’s purchase price. 

Capitalization Rate = Net Operating Income / Purchase Price

This formula puts more emphasis on the acquisition cost of a specific property, as opposed to the current value of a property. While there is no drawback to using this formula at the time of purchase, it’s not ideal for properties purchased months or years prior. Using the purchase price from several months or years ago will incorrectly estimate a property’s potential return. Similarly, this formula works poorly for homes that have been inherited because the purchase price is zero. As a result, using this formula can result in unrealistic expectations. 

To estimate the net operating income of a property, you will need to calculate the annual rent by multiplying the monthly rent by twelve. Once you have calculated the annual rent, you will need to subtract expenses. Expenses should include taxes, utilities (if not paid by the resident), property and liability insurance, and maintenance. 

If you are unsure of the monthly rent, we recommend that you research similar properties in the same area. You’ll need to look for other properties that have similar amenities. Identifying several similar properties will help you accurately estimate your monthly rent for a property. 

Why don’t the capitalization rate formulas account for financing 

Capitalization rates do not account for property acquisition costs like interest and closing costs for a very specific reason. The cost of acquiring a property will vary significantly depending on current interest rates, type of loan, and your particular closing costs. While other formulas can account for these costs, capitalization rates are designed to provide a baseline rate of return, regardless of loan repayment or interest rates. Excluding acquisition costs ensures that investors compare potential properties based on possible returns without factoring in highly variable costs unique to each individual. 

When you shouldn’t use capitalization rates to assess real estate properties 

You should not use capitalization rates to evaluate a property if you plan to use the property as a vacation or short-term rental. The potential income, occupancy, and expenses are too variable to assess a property accurately. 

While capitalization rates are a helpful tool, they have limitations that can be illustrated using two hypothetical properties. Let’s imagine that the first property has a net operating income of $50,000 and the current market value of the property is $600,000. In this example, the capitalization rate is 8%. 

Property #1 = ($50,000 / $600,000) x 100% = 8%

In the second example, a property has a net operating income of $40,000 and is currently valued at $400,000. The capitalization rate for this property is 10%. 

Property #2 = ($40,000 / $400,000) x 100% = 10%

If you only consider capitalization rates, the second property is the better investment. However, each investment opportunity has unique characteristics that should be considered. While the second property has a better capitalization rate on paper, it could be located in a less desirable location or have fewer amenities. As a result, the first property might be a better investment, even if it has a lower cap rate. 

How to use capitalization rates to your benefit 

Capitalization rates are one tool for gathering information and comparing potential rental properties. Individuals can identify the best investment for their financial picture and goals with more details. 

When calculated correctly, capitalization rates can indicate the length of time needed to recover the amount invested into the property. For example, a cap rate of 10% will require around ten years to recover the amount invested in the property. 

Understanding what constitutes a ‘good’ cap rate

It may be tempting to look for a potential investment property with “good cap rates.” However, it’s essential to understand that capitalization rates are not evaluated as good or bad but rather as an expression of potential risk.

A higher capitalization rate corresponds to more risk, and a lower cap rate is associated with less risk. Your ideal cap rate will depend on how much risk you’re comfortable taking. Generally, capitalization rates will fall somewhere between 4% and 10%.

You should assess capitalization rates in the context of the specific property and the current real estate market. As a general rule, you can expect capitalization rates to increase whenever interest rates rise. An increase in interest and capitalization rates will significantly impact anyone who owns a rental property. 

All things being equal, a lower cap rate equates to a better valuation and a better prospect of returns with less risk. Conversely, a higher cap rate will likely result in a relatively lower ROI and a higher level of risk. 

In real estate, properties are rarely equal. One property may generate more rental income but has more maintenance costs and higher taxes. Ideally, you want to identify a property with a reasonable cap rate relative to the amount of risk in purchasing a specific property.

How Belong supports the success of your real estate investments

A successful real estate investment strategy requires you to identify the ideal property, maintain a positive cash flow, and manage the investment effectively. Belong helps homeowners increase their profits and limit the hassles of owning an investment property.

When it’s time to price your property, Belong uses data and real-time insights to help you maximize cash flow. We also offer guaranteed rent, which means you never worry about less than 100% occupancy, which helps keep your investment safe. 

Learn more about Belong and see its role in your real estate investment strategy.

Understand how cap rates are calculated to identify the best methods for assessing a potential rental property investment.

Weigh up the costs and value of outsourcing the management of your rental home.

How to Estimate the ROI of a Property Manager

As a rental property owner, you’ll need to account for property management costs and identify the best solutions for your needs. For some, managing your own property can be an attractive way to maintain a positive cash flow. Still, it’s helpful to understand the potential ROI of a property manager. When you compare do-it-yourself property management against other property management solutions, you can decide which option provides the most value based on the cost.

Managing your own rental property can be a good choice for some. If you understand all the responsibilities of managing your own property and feel confident in your ability to execute those tasks, DIY property management might be right for you. If you choose to self-manage your rental property, there may be a financial upside. Still, you need to account for all the costs.

If you choose to self-manage your rental property, you’ll likely still need the support of a few key professionals. Most individuals who manage their own properties will engage the services of accountants and tax professionals. Likewise, you may need to hire professionals to complete specialized repairs or for ongoing lawn maintenance or pest prevention. Carefully factor these costs into your estimated expenses. 

Similarly, you should carefully estimate the costs associated with the tools and equipment needed to self-manage your rental property. You will need to use accounting software, a tenant verification tool, a computer, and internet access. Be sure to account for all mileage, cleaning supplies, and maintenance tools. 

Finally, you must account for the time spent managing your rental property. You may find it quickly becomes your most significant expense.  

While it may be tempting to see your time as cost-free, you may find that you are underestimating the value of your knowledge, expertise, and time. Consider assigning a specific value to each hour of your time. What do you consider your hourly rate? Is it $30, $60, or $100 per hour? 

Property management responsibilities will fall into several categories:

Sales & Marketing - advertising the rental

Tenant Selection - selecting a qualified tenant

Accounting - keeping track of the books and taxation requirements

Legal - understanding State and local laws, insurance needs 

Maintenance - keeping the home in good condition

Estimate how many hours you’ll need to spend completing these tasks per month or year. 

Time is the most valuable asset we have. It’s also the most limited. Carefully consider how much you value your time. What if you could be on vacation, spending time with your family, or enjoying something you love instead of managing your rental property? Does that increase how much you value your time?

Mental, emotional, and physical costs of managing your own property

The cost of self-managing your own rental property can transcend a specific dollar amount. Every rental property presents different challenges. Do you feel prepared to tackle difficulties that arise? What happens if rent isn’t paid on time? Are you familiar with and confident with taxes and insurance? Do you have a plan for handling emergencies? 

Self-managing a property requires finding, hiring, and managing contractors. How will you respond if they don’t show up or don’t complete work in a satisfactory manner? 

Do you consider yourself an organized individual? You’ll need to keep records like initial applications, credit checks, and lease documents diligently. To maintain a positive cash flow, it’s essential that you carefully track and record all expenses. 

Managing a rental property can also be physically demanding. Consider who will complete all of the maintenance requests. You may be required to climb ladders and move through attics or crawl spaces. Maintenance can be difficult and unpleasant at times. If you do choose to hire someone to help with maintenance, even little repairs can add up quickly. Before long, you may exceed your maintenance budget.

While property management solutions come with drawbacks and additional costs, it’s essential to understand what they offer and how they can impact your bottom line. 

What services do property management companies offer?

Perhaps most importantly, you need to know that not all property management companies offer the same services. If you explore working with a property management company or individual, compare their offerings carefully. 

Common property management services can include:

Marketing your home- suggest pricing, photos, videos, listings, ads

Tenant screening- rental history, credit check, background check, referrals, and employment verification

Rent collection- enforcing late fees, warnings, eviction notices

Repair and maintenance services - some may have an in-house maintenance crew, others may hire contractors

How much does property management cost? 

The cost of property management will vary significantly depending on the services being offered, the number of properties you are working with, and the location of your rental property. Property management packages can sometimes start for as little as $200. Most property management services will charge a percentage of the monthly rental value, typically between 6-12%. 

Critically, there are often additional costs and fees associated with property management. So while an initial package may only cost $200 or 6% of your monthly rent, extra expenses can add up quickly. 

Common property management fees to watch out for:

Carefully evaluate each property management solution for its offers and how much it costs. Be sure you understand what fees may be applied. With careful consideration, you can evaluate property management’s impact on your cash flow. 

What if there is another option? Meet Belong.

Imagine a modern alternative to property management. Would you be interested in a contemporary solution for property management without hidden costs and fees? Belong makes renting your home enjoyable and easy. We’re reinventing and modernizing the traditional home rental experience. 

What is the ROI of a property manager compared to DIY property management? We weigh up the costs and value of outsourcing the management of your rental home.

Understanding how to implement and calculate prorated rent in your rental home can help ensure you maintain a positive cash flow between leases.

What is Prorated Rent and How to Calculate it

Understanding how to implement and calculate prorated rent will allow you to lease your rental property to ideal residents and ensure you maintain a positive cash flow between leases. 

Prorated rents allow you to rent your property to a new and existing resident for a period less than your typical lease term of a month. Depending on your unique circumstances, you may have a resident who wants to move in on a day other than the first of the month. Similarly, residents may move out before the end of the month or need a few additional days or weeks before they move out. Prorated rent is rent that is calculated proportionately to the monthly rental amount.  

Prorated rent is equal to the daily rental rate multiplied by the number of days the residents will rent your property outside the current lease terms. 

Prorated rent = Daily rental rate x Number of days

You can calculate the daily rental rate by dividing the monthly or yearly rent by the number of days in the month or year. When you calculate the daily rental rate, there are four methods you can choose from. 

Daily rental rate based on the current month: Calculate the prorated rent by dividing the number of days in the month by the monthly rent and multiplying it by the number of days in the prorated rental period. 

Daily rental rate based on the average month: The average month has 30.42 days. To calculate prorated rent using the average month, divide the monthly rent by 30.42 and multiply it by the dates included in the prorate rent period.    

Daily rental rate based on the banker’s month: To calculate the daily rental rate using a banker’s month, calculate the prorated rent using 30 days in a month. Use 30 days regardless of how many days are in the month you are charging prorated rent. 

Daily rental rate based on the number of days in a year: Instead of calculating based on the days in a month, calculate the daily rental rate using the number of days in the year and the annual lease amount. To do this, multiply the monthly rent by twelve to find the yearly rent amount. Divide the annual rent by the number of days in the year (365 unless it’s a leap year) to find the daily rental rate.

Once you’ve chosen a method and identified the daily rental rate, you can multiply that rate by the days the residents will rent the property to find the prorated rent amount. 

Let’s imagine the monthly rent for your investment property is $2,000, and you have a resident who would like to move in 10 days before the beginning of their new lease. We can calculate the prorated rent amount using the formula above and our chosen method of finding the daily rental rate. Let’s assume that the current month is February, which is not a leap year. 

Prorated rent using the current month’s daily rental rate in February: 

$2,000 monthly rent /29 days = $68.97/day x 10 days = $689.70 

Prorated rent using the average month daily rental rate: 

$2,000 monthly rent /30.42 days = $65.75/day x 10 days = $657.50 

Prorated rent using the banker’s month (30 days) daily rental rate:

$2,000 monthly rent /30 days = $66.67/day x 10 days = $666.70 

Prorated rent calculated based on yearly rent: 

Depending on your method, you can see a slight difference in the prorated rent amount. There’s no wrong way to calculate the daily rental rate, but it is critical to use the same method consistently. This will allow you to answer any questions your residents may have about the prorated rental amount. 

There are two main situations where it is appropriate to use prorated rent. In both cases, prorated rent can aid in creating a smooth rental transition. 

When a resident moves in mid-month, let’s say your last resident moves out, and it takes you several weeks to find a new resident. They may move in on the 18th instead of waiting until the 1st of the following month. In this case, you’ll want to charge prorated rent from the 18th to the end of the month. 

Alternatively, when a resident wants to move out two weeks after the end of their year-long lease, imagine you have a resident who would like to move out on January 14th instead of December 31st. If you agree with their request, you will charge prorated rent from January 1st to January 14th. In this example, you would charge the prorated amount at the beginning of the last month. 

If you offer prorated rent when a resident moves in, consider charging the first month’s rent plus the prorated rent. You can collect this amount before your new resident moves in. Once the next month, charge rent as outlined in the lease agreement. 

Suppose you are charging prorated rent when your resident moves out. In that case, you can charge prorated rent at the same time and in the same manner as you typically collect rent once you’ve calculated the amount. 

Should you include prorated rent in your lease agreements? 

It can be helpful to outline in what situations and how you will charge prorated rent in your lease agreement. Ultimately, the goal is to communicate the process with your residents, so there is no confusion when these situations arise. 

Make it straightforward for your residents to understand how prorated rent works. Remember that they may not be familiar with prorated rent or know precisely how it works. Simple, proactive communication can have a positive outcome for everyone. 

As always, you should work with an attorney to ensure your lease meets local requirements and effectively communicates expectations to your residents. 

How prorated rent can help you find new residents 

Prorated rent can be a helpful tool in attracting new residents to your rental property. If you can offer potential residents flexibility using prorated rent, you can encourage a high-quality resident to choose your property over another. Similarly, a positive move-in experience which may include prorated rent is a good way to retain excellent, respectful residents.

If you're worried property management fees will hurt cash flow on your rental (they can!) learn how to avoid hidden fees and negative impacts on rental income with an alternative solution.

Will Property Management Fees Hurt My Cash Flow?

Due to high costs and hidden fees, traditional property management companies can negatively impact your cash flow and ROI. However, Belong offers homeowners a modern alternative to property management that’s much better for cash flow.

Carefully calculating cash flows alongside other financial metrics will allow you to estimate rental management expenses. With this information, you can evaluate the positive potential financial impact Belong can offer homeowners. 

Cash flow is an essential financial indicator for anyone renting out a home. It’s part of a bigger picture that helps you assess the costs and profitability of managing your rental home. You can calculate the cash flow of your rental property using a simple formula. 

Cash Flow = Total Income – Total Expenses

In calculating your cash flow, it’s essential to account for all the expenses associated with your property. These include, but are not limited to:

How is cash flow related to the ROI of a rental property?

A cash flow analysis provides critical information for understanding the return on investment (ROI) of a rental property. Ideally, you’ll want your rental home to have a positive cash flow. A positive or gross cash flow confirms that you are bringing in more money than it costs to pay for and manage your rental home.  

If your rental home generates a positive cash flow, you can use it to calculate the return on investment for that property. Calculate the ROI of your rental home by dividing the annual return by your actual expenses, which include the down payment, closing costs, and any home improvements.  

What’s a good cash flow or ROI for a rental property?

An accurate cash flow analysis and ROI calculation will provide a critical indicator that can help you create a better financial plan. While each individual will have different goals and priorities, an ideal ROI is about 8%. Depending on your individual circumstances, an ROI of 6% can also be good.

How to look beyond cash flow for a complete financial picture

Once you’ve calculated the cash flow and ROI for your current or potential rental property, you can consider other financial metrics to provide more context for your investment. 

The 50% Rule offers real estate owners and investors a shortcut for calculating the ROI of a rental property. The rule assumes that 50% of your rental income will go towards operating expenses. Expenses include property taxes and insurance but do not include principal or interest payments. 

The 50% Rule should not be used in place of past expense calculations, as historical data will always provide the most accurate insights. However, you can use it as a benchmark in evaluating rental properties. If you plan to use the 50% Rule, we highly recommend that you also use other financial metrics to assess the financial well-being of your rental home. 

If your rental home currently has a mortgage, the 1% Rule (or 2% rule, both are common) is a helpful way to evaluate how the property can provide you with the desired cash flow and ROI. The rule suggests that the monthly rental income should equal or more than one-two percent of the purchase price. While the rule is not comprehensive and is often considered outdated, it offers a good starting point for assessing how much rent to charge. 

At Belong, we use even more data to consider current trends, market, and real-time property value to identify the best listing price. We also understand that local charms, unique features, and the community can impact pricing. We help you get the ideal pricing to achieve a positive cash flow. 

Read More: How to price your home on the rental market

One of the most critical real estate calculations used to evaluate the ROI of a property is cash-on-cash return. This metric measures the return on investment for a limited time, typically a year. You can also use a cash-on-cash return or cash yield calculation to forecast future earnings and expenses.

Cash-on-Cash Return= Total Cash Invested/ Annual Pre-Tax Cash Flow

A cash-on-cash return is the percent of the investment you make back on this year in cash flow. Essentially, the pre-tax calculation looks at cash flow in relation to the amount of money that has been invested in the property. Cash-on-cash measures the return on the invested money, making it ideal for properties with long-term debt borrowing. 

Factors that contribute to negative cash flow

You should continually calculate cash flow to assess a rental property’s financial success. Often, successful rental homeowners can be financially derailed thanks to a few specific factors. 

Poor cash flow calculations at the time of purchase or rent 

If you have used financial metrics incorrectly or poorly estimated potential cash flow for a rental property, it’s hard to course-correct. You may be able to reduce expenses or increase rental pricing to rectify the situation. Still, you’re unlikely to recoup all losses. Carefully calculating financial estimates is critical for avoiding negative cash flow. 

Every week or month that your rental home goes unleased will negatively impact your overall cash flow. It’s essential that you quickly prepare, list, and market your home to attract ideal residents. 

Did you know Belong homeowners get guaranteed rent, even when their home is vacant? Learn more about Smooth Payments™ and see if you qualify here.

Maintenance can be a cash flow and budget breaker. While it’s challenging to plan for unforeseen expenses, it’s often delays, unresponsive service providers, and complex repairs that affect cash flow most. 

Ways to minimize the likelihood of negative cash flow

With help, you can reduce the likelihood of negative cash scenarios. Limiting the risk of a negative cash flow requires a focus on:

Conducting regular, preventive maintenance and finding competent, experienced professionals who complete work quickly and cost-effectively. 

If you're worried property management fees will hurt cash flow on your rental (they can!) learn how to avoid hidden fees and negative impacts on rental income

Jordan Newsom

Jordan Newsom is a highly-caffeinated writer who loves delighting readers, using content to teach, and broadening perspectives. When she's not behind a computer screen, she's hunting down the best coffee shops, breweries, and restaurant patios in Denver, Colorado.

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