# Part 2... Using Cap Rates Wisely

By
Real Estate Agent with Keller Williams Realty - Topsfield, MA 92593-B

This is Part 2 and the final blog post on Capitalization Rate, How to calculate and use them wisely. I hope you enjoy and find it useful, especially if you are a budding investor.

Using Cap Rates Wisely

1

Use cap rates to quickly compare similar investment opportunities. The cap rate basically represents the estimated percent return an investor might make on an all-cash purchase of the property. Because of this, cap rate is a good statistic to use when comparing a potential acquisition to other investment opportunities of a similar nature. Cap rates allow quick, rough comparisons of the earning potential of investment properties and can help you narrow down your list of choices.[6]
• For example, let's say that we're considering buying two pieces of property in the same neighborhood. One has a cap rate of 8%, while the other has a cap rate of 13%. This initial comparison favors the second property. It has a higher cap rate, so it is expected to generate more money for each dollar you spend on it.[7]

2

Don't use cap rate as the sole factor when determining an investment's health.While cap rates offer the opportunity to make quick, easy comparisons between two or more pieces of property, they're far from the only factors you should consider. Real estate investment can be quite tricky - seemingly straightforward investments can be subject to market forces and unforeseen events beyond the scope of a simple cap rate calculation. At the very least, you'll also want to consider the growth potential of your property's income as well as any likely changes in the value of the property itself.[8]
• For example, let's say that you buy a piece of property for \$1,000,000 and you expect to make \$100,000 per year from it - this gives you a cap rate of 10%. If the local housing market changes and the value of the property increases to \$1,500,000 suddenly, then you may have less-lucrative cap rate of 6.66%. In this case, it may be wise to sell the property and use the profits to make another investment. However, it is also possible that the income levels may have increased, or the expense levels may have decreased. Make sure to look into all of the factors involved when determining the cap rate.

3

Use the cap rate to justify the income level of the investment property. If you know the cap rate of properties in the area of your investment property, you can use this information to determine how much net income your property will need to generate for the investment to be "worth it". To do this, simply multiply the property's asking price by the cap rate of similar properties in the area to find your "recommended" net income level. Note that this is essentially solving the equation (Net income/Asking price) = cap rate for "net income".
• For example, if we bought a property for \$400,000 in an area where most similar properties have about an 8% cap rate, we might find our "recommended" income level by multiplying 400,000 × .08 = \$32,000. This represents the amount of net income the property would need to generate per year to get an 8% cap rate. However, keep in mind that you cannot set rental rates based on the cap rate. They must be based on market rates and consider how this rental would compare to other rentals in the area.

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I pray that God our Father and the Lord Jesus Christ will be kind to you and bless you with peace

2 Thessalonians 1:2

Doug Dawes REALTOR®, AWREP, LMC

Broker Sales Associate

KELLER WILLIAMS REALTY - Topsfield/Newburyport

49 Main Street
Topsfield, MA 01983
978-887-3995  ~ Office
978-270-3037  ~ Cell
DougDawes@KW.com

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