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Today, I am going to discuss with you how to calculate capitalization rate and why this is a must when investing in real estate.
In order to invest in real estate in income producing properties you must have a method in determining the value of the property you're considering buying and by utilizing the tool of calculating cap rate you can quickly weed out homes that may or may not be a good investment.
So what is cap rate?
Definition: Capitalization rate defines the percentage number used to determine the current value of a property based on estimated future operating income. In other words, taking the net operating income from an apartment complex and dividing it by the capitalization rate would yield the approximate current value of the complex.
The capitalization rate would be determined based on an appraisal and/or the cap rates of similar properties that have sold recently. By taking another apartment project that sold recently, determining it's net operating income (NOI), you would divide the income by the sold price to get the cap rate.
When I review homes, I personally with some exceptions look for properties that have cap rates of 10% or better. For me, this guarantees that once I put money down and purchase the home, that I am immediately cash flowing. Many investors will be happy with less, for me its a number that I try to stick to and have found success.
The Cap Rate is computed by taking the rental net operating income (NOI) and dividing it by the property's fair market value (FMV). The higher the Capitalization Rate is the better.
Cap Rate - Practical Use #1
You can use the Cap Rate to value your property. Let's say that your property generates $10,000 of annual net operating income. Your real estate agent tells you that the Capitalization Rate in your area is approximately 4%. That would mean that the approximate fair market value of your property is $250,000 ($10,000 / .04).
Cap Rate - Practical Use #2
Let's assume that you are looking at investing in two properties. The first property has a projected NOI of $20,000 and an asking price of $500,000. The second property has a NOI of only $10,000 but an asking price of $110,000. Which one would the Cap Rate suggest is a better investment? That's right, the second property since the Cap Rate is 9% ($10,000 / $110,000) versus 4% ($20,000 / $500,000).
Hopefully the above has helped you both understand the benefit of understanding what cap rate is and how to determine what it is for your own properties or others that you are considering investing into.
Want additional information or assistance in finding a great home? Contact me direct for a free consultation where we will work on a personal plan for your own success!