Investing in the real estate is one of the most profitable businesses in the world. However, most investors face a huge challenge in determining the income of a certain building property. Usually, most of the investors rely on two factors while evaluating income prospects from a building; the strategic location of the property and the probability of economical changes in the neighborhood. Though these two factors might be worth taking into consideration, they might be misleading. One certain method that can effectively help an investor to make an informed decision is the capitalization rate.
A common mistake made by those just getting started with real estate investing is to think that there is no one ideal cap rate. But capitalization rates vary from area to area and from investor to investor. The cap rate for an apartment complex in Los Angeles, for instance, would not be expected to be the same as it would be in Boston, or that one capitalization rate would satisfy the investment goal of all real estate investors. Furthermore, it’s necessary to bear in mind that cap rate alone do not provide an accurate picture of a property’s profitability and is not generally used apart from other criteria to make real estate investment decisions.
Capitalization rate, at best, should merely be considered a rule of thumb that provides the first-glance assessment of a rental property’s ability to pay its own way; thereby used by real estate agents, appraisers, investors, property tax assessors, and other real estate analysts
The Capitalization Rate
Also known as the cap rate, Capitalization rate is the measure of profitability of an investment. Capitalization is a way of determining the rate of return on an investment property. Cap rates tell you how much you’d make on investment if you paid all cash for it (financing and taxation are not included). To evaluate the cap rate, one must know the price of the property and the net operating income which creates the following equation:
Cap Rate = NOI / Price of Building or NOI / Cap Rate = Price of Property
The capitalization rate is useful when you want to arrive at a rough listing or resale price quickly and easily. When you would like to propose a price for a particular rental property based on the market cap rate or a customer’s desired capitalization rate, for example. Below is an overview of the necessary steps in calculating the cap rate using a scenario situation:
Step 1: Determine gross income
The first step should be the calculation of the gross income generated from the apartment within one year. Basically, the income will be defined by the rent rolls received during that period. However, in some instances, you should include miscellaneous income that might accrue from the apartment in the form of coin-operated vending or washing machines, etc.
Case Scenario: Assuming that you have purchased an apartment that you would like to rent it out to tenants at a monthly rate of $1000, and you also get $300 from washing machines operation throughout the year. The gross annual income would amount to $1000 * 12 + 300 which would translate to $12, 300.
Step 2: Determine the Net Operating Income
Just like any other business venture, real estate is subject to incurring expenses. Normally, you will record operating expenses in any property that you acquire. The most popular expenses are maintenance costs, property management expenses, insurance, home warranty (visit this website for more info) and taxes paid to the federal government. For you to reach the net operating income, you should deduct all the operating expenses from the gross income computed in step 1. The final figure you will reach at will be the net operating income from the property.
Case scenario: After purchasing a property, you find that you will be expected to $500 to the maintenance staff, $500 in insurance per year for our property, $850 in property management and a staggering $800 in taxes to the authorities. The total operating expenses will be $2650 per year.
Net operating income = $12300 – $2650
This will give you $9, 650 for that year as the net operating income.
N.B.: Note that the cap rate does not account for any other expenditure incurred in the business. As a result, expenses such as mortgage payments, the initial purchase price for the apartment, legal fees paid to lawyers or any other fee should not be included when calculating cap rate. Since these items reflect the investor’s standing with the lender and are mostly of variable nature, they adversely affect the neutral comparison that the cap rate is meant to deliver.
Step 3: Determine the cap rate
Cap Rate = NOI / Price of Property
According to this method, you should take the net operating income from the property then divide it with the original price of the property. Cap rate is normally expressed as a percentage.
Case scenario: Assuming that you purchased your proprty at $50, 000. Given this information, we now have ll that we need to know to find our cap rate. See below:
— $12300 (gross income)
— $850 (property management)
— $500 (maintenance)
— $800 (taxes)
— $500 (insurance)
— =$9650 (net income) / $50000 (purchase price) = 0.193 =19.3% cap rate
But how do we know if this is a good rate of return? The best way to judge how good the rate is is by reviewing comparable sales’ rates. If the similar properties have a lower cap rate, then the 15% is a higher than average rate and could be considered a deal. Capitalization rates are also directly affected by interest rates and correlate when they go up or down. Similarly, each type of property and each market has cap rates that differ from different property types and markets. It is best to do substantial research into what type of property you’re looking to invest and what typical financials are for those that are sold in that particular market and price point.
When purchasing a property, one should be cautious to ensure that he correctly estimates the values of the property in order to pay the right price. You should thoroughly research in the region and consult real estate services experts before reaching at a conclusion. Cap rates are just one of many ways to analyze a property, but they are a fundamental form of investment analysis and should be done on any investment property to determine if it’s worth the asking price.