Unlocking The Secrets of CAP Rates

Tim Ford

As you drive through Bozeman, you can’t help but notice the flurry of newly constructed  apartments sprouting up everywhere. It’s a clear sign of the city’s thriving rental market, attracting investors from far and wide. In this article, we’ll delve into the world of Cap Rates, a crucial concept for income property investors.

What is a Cap Rate?
A Cap Rate, short for Capitalization Rate, represents the annual rate of return on a property investment. Think of it as the rate of annual income a property would generate if you paid cash for the property. It’s a simple yet powerful tool for evaluating the potential of an income property.

The Cap Rate Formula
Net Operating Income (NOI) ÷ Purchase Price = Cap Rate
To calculate the Cap Rate, you need to determine the yearly Net Operating Income (NOI) by subtracting taxes, insurance, and maintenance fees from the potential Gross Income. Then, divide the NOI by the purchase price of the property.

A Real-World Example
Let’s say an investor purchases a duplex in Bozeman for $775,000, with each unit renting for $2,250 per month. The taxes cost approximately $4200 per year, insurance is another $2500, the water/sewer bill is $2400 per year, and there’s been an average of $1500 per year in maintenance. The property brings in $54,000 gross rents per year ($2250 x 2 x 12), but after deducting taxes, insurance, and maintenance, the property nets $43,400 per year. This is the NOI. $43,400 divided by the $775,000 is .056, or 5.6%. This is the investor’s Cap Rate, or yearly rate of return on their investment.

Using Cap Rates to Compare Investments
Cap Rates allow you to compare different properties to one another, or to compare real estate investments to other assets, like stocks or bonds. However, keep in mind that Cap Rates don’t account for tax benefits or potential appreciation, which can impact an investor’s actual rate of return.

Running the Cap Rate Backwards
An investor can also use the Cap Rate to estimate a property’s value. If you know the Net Operating Income and the prevailing Cap Rate in a market, you can calculate the property’s worth. For example, if a multi-unit building generates $68,750 in NOI and the local Cap Rate is 5.5%, you can estimate the property’s value to be around $1,250,000. ($68,750 / .055 = $1,250,000)

Understanding Cap Rates is one of the many crucial pieces in making informed decisions in the world of income property investing. By grasping this concept, you’ll be better equipped to navigate the market and make smart investment choices. Happy investing!
I have also included recent sales data for the first four months of 2024. In addition to the 184 homes sold both inside and outside Bozeman city limits, another 100 home sales are currently under contract or pending, as of this writing. This compares to 116 home sales pending at this same time last year.

The included data reflects sales of homes in the greater Bozeman area, including Four Corners, Gallatin Gateway, Bridger Canyon, and within Bozeman city limits. The data includes home sales reported through the local Big Sky Country MLS, and does not include private party sales, condominiums, or townhouses.  

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