Anyone who is going to invest in real estate should understand the financial terms and tools involved in real estate investing. If you are looking for income property, then one of the most important and least understood tools to determine if you are making a good real estate investment is the Capitalization Rate or (Cap Rate).
What is the Cap Rate? And how do I apply it to my investment research?
The Cap Rate is a measure of the ratio between the net operating income produced by an asset (usually real estate) and its capital cost (the original price paid to buy the asset) or alternatively its current market value. The rate is calculated in a simple fashion as follows:
* annual net operating Income (NOI)/ cost (or value) = Capitalization Rate
For example, if a building is purchased for $1,000,000 sale price and it produces $100,000 in positive net operating income (the amount left over after fixed costs and variable costs are subtracted from gross lease income) during one year, then:
* $100,000 / $1,000,000 = 0.10 = 10%
The asset’s capitalization rate is ten percent. Good luck finding a cap rate at this rate. (If you do, you should seriously consider buying the property. Of course, after careful analysis of the expenses and any hidden costs.)
Capitalization rates are an indirect measure of how fast an investment will pay for itself. In the example above, the purchased building will be fully capitalized (pay for itself) after ten years (100% divided by 10%). If the capitalization rate were 5%, the payback period would be twenty years. Note that in real estate appraisal in the U.S. use net operating income. Cash flow equals net operating income minus debt service. Where sufficiently detailed information is not available, the capitalization rate will be derived or estimated from net operating income to determine cost, value or required annual income.
Remember that the Cap Rate is a valuation calculation as well. The capital cost (property price paid or paying) = Your Estimated Cash Flow / Cap Rate.
Another Example of this is: If you are expecting a net cash flow of $20,000/year and the cap rate published by the seller is 6.5% than the price we would pay would be $307,692. Not a penny more. And if you are smart you will try to buy this property for about $200,000. Which is 65% of the estimated value. Remember those hidden costs and deferred maintenance issues that are lurking!
While these types of deals are hard to find, the cap rate calculation still applies and you should NEVER pay more than the estimated value using the reverse cap rate calculation.