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Demystification of an important number
Beginning property investors can easily become overwhelmed by the seeming complexity of an array of number crunching analyses experienced property investors run. And usually, the more experienced, the more they run these numbers. Usually, in their heads alone. But novices will need initially at least, have to use pencil and paper…or plug in numbers to software programs (see the Tools section of this site for one excellent calculator).
One of the most important calculations any property investor needs to run is the capitalization rate (CAP rate). It will yield a number to be used like the North Star is used for seafarers – a directional arrow to compare potential properties, and to gauge which properties may throw off better future returns, based on a specific price. Thus, the CAP rate will help narrow down choices of different property investments to help you determine the best ones for you to pursue, as well as guide you, like the North Star, towards negotiating a price above which, the property makes no financial sense to continue pursuing.
How the CAP rate works
So let’s break down the CAP rate first. Consider it as a simple tool to measure the annual rate of return on your property investment. Different geographical areas will have different CAP rates. In general, the more in demand an area, the greater the CAP rate. And vice-versa. Thus, higher demand areas will usually yield CAP rates much greater than lower demand areas. CAP rates, in general, tend to run between 4 to 10 percent for investment properties.
Doing the math
The calculation for the CAP rate is easy; simply follow this order: ascertain the annual rent roll from a given investment property (making sure to double check and confirm any seller-given figures). If there are vacant units in the building, you’ll need to ascribe a correct market rent for each unit. Make sure you check out several Realtor’s estimates, Craigslist listings, and have actually visited like units in other buildings to help determine accurate rent roll pro forma numbers. Then add up all the expenses associated with the building, on an annualized basis. Don’t forget a vacancy amount (usually between 5 to 10 percent of total rent roll, as well as maintenance, taxes, insurance, electric, heating, and any other utilities the tenant will not be paying directly for. Of course, unless you’re paying all cash for the property, you’ll need to add in your mortgage payment on an annualized basis as well. Once you subtract the total expenses from the pro forma total income, you’ll have your (hopefully) positive cash flow number. This, of course, is your net income.
Calculating the CAP rate
Now simply divide the net income figure by the amount the seller is asking for the property. (As an example, if a property that throws off $10,000 in net income has an asking price of $100,000, then the CAP rate would be $10,000/$100,000, or 10%.) To reiterate, the greater in demand the area, the greater the CAP rate should be. In addition, you need to set minimum standards for yourself. Some investors won’t buy anything with a CAP rate below 5%. That’s up to you. But be sure to use the CAP rate to help you back into the highest amount you would offer for a property. The CAP rate can represent your rate of return on any given investment property. After you run a few hundred of these calculations, you too will be able to compare properties in your head within minutes.
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