What is a Cap Rate?

A Short-Term Rental (STR) Capitalization Rate (Cap Rate) is a vital metric used to evaluate the profitability of a short-term rental property. The cap rate represents the expected annual return on investment for a property, expressed as a percentage. It is calculated by dividing the property’s Net Operating Income (NOI) by its current market value or purchase price. Understanding the cap rate helps investors assess potential returns, compare different properties, and make informed decisions about property purchases and pricing. By calculating the cap rate yourself, you can gain a clearer understanding of your potential return on investment (ROI). Let’s explore how to calculate it using a target property on Vieques, listed for $800,000.

How to Calculate Cap Rates.

To calculate your STR cap rate, you’ll follow three steps. First, determine the annual gross rental income. Estimate the property’s yearly revenue from bookings by researching similar properties in the market and their rental histories or obtaining past revenue figures from the seller if the property is already a short-term rental. Keep in mind that past performance is no guarantee of future results, so arrive at a realistic gross rental income figure that aligns with market conditions. For example, let’s say the target property generates $130,000 in annual gross rental income.

Second, subtract annual operating expenses. These expenses cover the costs of managing and maintaining the property. Typical costs include cleaning fees for regular guest turnover, maintenance for routine upkeep such as pool and lawn care, property management fees for handling reservations and emergencies, utilities like water and electricity, HOA fees if applicable, taxes including property and tourism taxes, and insurance for both property and liability coverage. If the property is already operating as a short-term rental, the seller may share these figures with you. The more years of rental history you have, the more accurate your projections will be. For our target property, annual operating expenses total $78,000. Subtracting this from the gross rental income of $130,000 leaves us with a Net Operating Income (NOI) of $52,000.

Finally, divide the NOI by the market value of the property. To calculate the Cap Rate, divide the NOI by the property’s market value or purchase price and multiply the resulting number by 100 to express it as a percentage. In our example, the NOI is $52,000 and the market value is $800,000, the calculation is $52,000 divided by $800,000, which equals 0.065. Multiply 0.065 by 100 to get a Cap Rate of 6.5%. In this example, the Cap Rate for the target Vieques property is 6.5%.

This Cap Rate can guide your financial decisions based on your investment goals. For instance, if you are satisfied with a 6.5% Cap Rate, the $800,000 price aligns with your purchase range. If your goal is a 4.0% Cap Rate, you can calculate the property value using the formula Property Value = NOI / Desired Cap Rate. With an NOI of $52,000, dividing it by 0.04 gives a property value of $1,300,000, making the $800,000 price seem like a bargain. Conversely, if you prefer a 9% Cap Rate, the property’s value would need to be sold at $577,000, calculated by dividing $52,000 by 0.09.

What’s considered a good Cap Rate?

A favorable Cap Rate for short-term rental properties generally falls between 8% and 12%. However, acceptable Cap Rates vary depending on factors such as location, property condition, and market trends. High-demand areas may have lower Cap Rates due to higher property values, while emerging markets might offer higher Cap Rates. Well-maintained properties can command higher rental rates, positively affecting NOI and Cap Rate. Additionally, economic conditions and tourism trends impact occupancy rates and rental income. On Vieques, some buyers simply want to buy a rental property with a positive Cap Rate, as they are looking for a place that will pay for itself, and which they can use for a few weeks of the year. They see it as a free vacation. Everyone’s Cap Rate is based on different goals.

While Cap Rate is a valuable metric, it has limitations. It does not account for financing costs or debt service, nor does it predict future changes in income or expenses. It should be used alongside other metrics, such as cash-on-cash return and occupancy rates, for a comprehensive investment analysis.

Calculating and understanding Cap Rates is essential for evaluating the profitability of short-term rental investment properties. While it provides a clear snapshot of potential returns, it is just one piece of the puzzle. Ensure you’re making informed decisions by consulting with an accountant or financial advisor before finalizing any property purchase. Paraiso Realty is here to guide you through every step of your real estate investment journey in Puerto Rico. Contact us today to explore opportunities in the vibrant Vieques market and beyond!

Below are three properties that Paraiso Realty currently has for sale, and would make great rental properties. Click on an image to see more details.