CALCULATING YOUR EXPECTED YIELD FOR RENTAL HOUSES
With all other forms of investment real estate, except rental houses, the value of the property is a function of the market Cap Rate applied to the Net Operating Income. A quick review: “Cap Rate” is short for capitalization rate. The Net Operating Income (NOI) is the total gross income minus the amount lost due to vacancy and delinquency, minus the amount of all the operating expense but NOT including any reduction for debt service (mortgage principal and interest payments). Divide the net operating income of the property by its price and you have the Cap Rate (%). When sellers price their investment properties they determine what the market is willing to pay as a Cap rate and apply that toward their net operating income. So buyers can apply their desired Cap Rate requirements toward all the NOIs of properties for sale to determine which properties best meet their investment expectations.
But this doesn’t work with rental houses. One day, when the rental house investor wants to sell, the most likely buyer is an owner-occupant. And the owner-occupant buyer doesn’t care what the house rented for and what the Cap Rate is. They are buying for other reasons related to neighborhood amenities, quality of the local schools, commute time, and many other factors. This is why it is important that investors who buy rental houses need to look at the Internal Rate of Return (IRR) rather than the Cap Rate or gross yield for a rental house. A lower quality property may offer a higher monthly cash flow but that house may not appreciate much. A higher quality property may not generate as much cash flow but may appreciate in value a great deal. The Internal Rate of Return calculation will take all factors, including anticipated appreciation, into consideration. Review HOW to “Quantify” the Quality of different Rental Houses (Blog 11/04/15). It may take a little longer to calculate IRRs versus Cap Rates but this is the only way to make a true “apples to apples” comparison of different investment opportunities. There are several Excel templates you can find and download on line to help you calculate IRRs quickly. We use a proprietary template which includes our estimates for vacancy, delinquency, and maintenance and repair costs based on our experience in the Atlanta market. As with any projection, just make sure your assumptions are realistic.
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