I found the following discussion on how to determine the Capitalization Rate for a piece of investment property to be helpful for new investors in Real Estate. I hope you enjoy the explanation. I was looking at this information to refresh my knowledge and maybe pick up some new knowledge.
Real estate investors rely upon a variety of types information when negotiating for income producing properties - for instance, the desirability of the property's current location and/or any prospective changes in the neighborhood are two common factors. One crucial piece of information that helps investors make their decision is called the capitalization rate (or "cap rate"). The cap rate (expressed as the ratio of the property's net income to its purchase price) allows investors to compare properties by evaluating a rate of return on the investment made in the property. If you are considering an investment property, then you may want to calculate the cap rate first and then use it to help you make your decision.
CALCULATING CAP RATE
- For example, let's say that we've just purchased a house we intend to rent to tenants at a rate of $750/month. At this rate, we can expect to make 750 × 12 = $9,000 per year in gross income from the property.
- For example, let's say that, after having our rental property appraised, we find that we can expect to pay $900 in property management, $450 in maintenance, $710 in taxes, and $650 in insurance per year for our property. 9,000 - 900 - 450 - 710 - 650 = $6,290, our property's net income.
- Note that the cap rate doesn't account for the property's business expenses - including the purchase costs of the property, mortgage payments, fees, etc. Since these items reflect the investor's standing with the lender and are variable in nature, they adversely affect the neutral comparison that the cap rate is meant to deliver.
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Let's assume we purchased our property for $40,000. Given this information, we now have everything we need to know to find our cap rate. See below:
- $9000 (gross income)
- -$900 (property management)
- -$450 (maintenance)
- -$710 (taxes)
- -$650 (insurance)
- =$6290 (net income) / $40000 (purchase price) = 0.157 = 15.7% cap rate
Calculate the yearly gross income of the investment property. The gross income of a piece of investment property will mainly be in terms of rent rolls. In other words, when a real estate investor buys a home, s/he usually makes money from it primarily by renting it out to tenants.[3] However, this isn't the sole possible source of income - miscellaneous income can also accrue from the property in the form of coin-operated vending or washing machines, etc.
- For example, let's say that we've just purchased a house we intend to rent to tenants at a rate of $750/month. At this rate, we can expect to make 750 × 12 = $9,000 per year in gross income from the property.
Calculate the yearly gross income of the investment property. The gross income of a piece of investment property will mainly be in terms of rent rolls. In other words, when a real estate investor buys a home, s/he usually makes money from it primarily by renting it out to tenants.[3] However, this isn't the sole possible source of income - miscellaneous income can also accrue from the property in the form of coin-operated vending or washing machines, etc.
- For example, let's say that we've just purchased a house we intend to rent to tenants at a rate of $750/month. At this rate, we can expect to make 750 × 12 = $9,000 per year in gross income from the property.
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