Do you understand what capacity rates are as a real estate investor? Don’t worry, if you don’t, you’re not alone. One of the single most common reasons potential investors don’t invest is because they think it’s too complicated or they don’t understand real estate jargon. Case in point, cap rates.
The facts are, however, that investors who understand cap rates are the ones who make the best returns on single-home investments in real estate. We explain the term and how exactly investors should be using cap rates in decision-making.
So why do cap rates matter?
Well, if you’re an investor, let’s just say it’s the difference between determining what your possible ROI might be and coming to a much closer scientific projection. While investing carries risk just by nature of the trade, the cap rate calculation can help prospective investors understand just what to expect on the performance of one or more rental homes they are looking at.
The capitalization rate (or “Cap Rate”) is a real estate valuation measure that is used to compare different real estate investments. Although there are many variations, a cap rate is often calculated as the ratio between the net operating income produced by an asset and the original capital cost (the price paid to buy the asset) or alternatively its current market value.
Example: The capitalization rate is the ratio of Net Operating Income (NOI) to property asset value. So, for example, if a property was listed for $1,000,000 and generated an NOI of $100,000, then the cap rate would be $100,000/$1,000,000, or 10%.
You can also look at it like an equation:
Take the property value and subtract known expenses…
When calculating the cap rate, investors look at the value of the property and compare it to the income that the property will bring in. Of course, any expenses that will accrue must be subtracted. Examples of expenses the investor should keep in mind include:
- Management expenses
Make sure that you do the research or work with your turnkey property company to identify what all of these expense will be. IndyREI provides all of these and more as part of our package when we work with investors.
Then subtract 10%…
Once you’ve calculated all of this, you need to minus another ten percent from the total in order to cushion your bank account when you have a vacancy down the road. This is a standard number to assume in order to protect yourself when the unexpected happens. We also make sure we talk in depth about you got it, location, location, location. We cut down on the likelihood of those vacancies by working in areas where rental demand is strong, which offsets the risk of vacancy.
Then divide this number by the purchase price…
After you’ve come up with your operating income (adjusted for operating expenses), you divide this number by the purchasing price you pay upfront. This tells you your cap rate, which is reflected as a percentage and will give you a very likely annual ROI.
Want to know more about cap rates or how a particular property would perform in today’s market? Let’s talk! IndyREI is ready to help you make the best investment decision!