Previously, I posted a blog that addressed investment real estate for beginners. In general, I wanted to outline some key things to consider when purchasing real estate as an investment. Now I would I like to delve a little more into determining a value for investment property. Value and price are obviously important components of buying an investment property, and there are many tools that people can use to find a value. In general, I do not adhere to one set rule for finding value. I have found that each property is different and there are numerous factors you need to consider. But many investors use certain methods to evaluate properties. For instance, gross rent multipliers, internal rate of return, and cap rates. All three are useful ways to compare and value investments. But the most commonly used is probably the “cap rate” or “capitalization rate”. You may or may not have heard people use this term. It can be confusing and misleading to buyers or new investors. I am not a text book writer, but I will try to explain or clarify the term and its use in real estate.
Generally, speaking the capitalization rate is a valuation used to compare real estate investments. A cap rate seeks to find a ratio in the relationship between a property’s income and its purchase price or value. To find the cap rate, you need to determine a property’s “net operating income” or NOI. Net operating income is all the income for a property minus the operating costs. For the purposes of a rental property, the operating costs include: property taxes, insurance, hoa costs, management fees, and other maintenance. When calculating NOI they DO NOT INCLUDE: debt, depreciation, income tax, and improvements. For example, if a property makes $18,000 a year after property taxes, insurance, etc. than the Net Operating Income (NOI) is $18,000. Please remember this DOES NOT INCLUDE a mortgage payment. Once you know the NOI you can find a cap rate. Below is a simple formula used to calculate a cap rate:
Net Operating Income(yearly) / Price = Cap Rate
Cap Rate X Price = Net Operating Income
It is a fairly simple formula. But you may have noticed something about this formula. Where do you get a number for price? Without price you cannot determine a cap rate. So essentially, you can make a cap rate whatever you want. One could simply make the price as high or as low as they want. What you need to understand is that the “cap rate” is just a way to express the relationship between the price and income. It is not ideal for finding value but better used to compare properties. Sellers offer investments at a price with a cap rate in mind but the real price is not determined until it is sold. In general, a higher cap rate means a lower value, but that could be a sign of a good buy depending on the market. You need to remember that cap rates are specific to the area. If cap rates are 7% in your area, and you find something at 9% than you may have found a good deal. But if cap rates are 11% in an area, and you find something at 9% than it may or may not be a good deal. Be sure to understand all the circumstances surrounding a property. This is another reason why it is helpful to find a professional to help you because knowing the local market is crucial when looking at cap rates.
I never like to talk over a client’s head, and cap rates seldom come up when I am working with someone to buy student rental property in Athens, GA. But it is a tool for many investors, and it never hurts any investor large or small to understand value methods. In the end, I am not a huge fan of cap rates. Expenses can vary year to year especially for large items and the interest rate on the mortgage is not considered. There are many types of investment properties. Hotels, warehouses, and commercial office buildings just to name a few. And cap rates are often be more applicable to these larger income properties. They can be useful, but it is not necessary for new investors to get too caught up with cap rates when buying individual rental properties.