Before you make any life decision, it is always recommended to weigh the pros and cons to determine which decision is best for you in the long run. Making a rational and calculated decision can have major implications on your quality of life and future decisions ahead. Assess, Evaluate, and then Decide. Because, no good ever comes from making uninformed decisions and hoping for the best to happen.
With this life lesson aside, real estate investing is all about making wise and smart investment decisions to reap off the maximum profits in the long term. For example, don’t expect to invest in a random investment property without any previous property assessment or knowledge about the housing market in the area or/and the overall economic conditions in the city and make a big profit. If you buy and flip a house in a lousy neighborhood without calculating the return on the investment or the capitalization rate, aka the cap rate, and you have a hunch it might sell well soon, then you are in for a big disappointment. In real estate investing, there is no such thing as buying a rental property on a whim and hoping for magic to happen. There is no coincidence when it comes to buying and selling real estate at a profit. If you want to succeed in this industry, you have to keep up with all the changing market and housing conditions to stay ahead of the game and see your real estate investment materialize in abundant ways.
All About the Cap Rate
Assessing each real estate property through key metrics is your weapon to decipher the good real estate investments from the bad ones. The capitalization rate, the aka cap rate, is one of those valuation metrics used in real estate investing to calculate the return on investment (ROI). Simply put, the cap rate calculates the annual gross profit rate based on the rental property’s expected income.
Mathematical Formula:
Cap Rate (%) = (Net Operating Income/Current Market Value) x 100
Net Operating Income (NOI) = annual rental income – operating expenses
Current Market Value (MV) = price of the property
Quick Example:
Property A has a NOI of $140,000, and its current MV reaches a lump sum of $1,500,000. Meanwhile, property B has a NOI of $130,000, selling at $1,000,000. If NOI remains the same, which one is a better investment for the real estate investor?
Cap Rate Property A = (140,000/1,500,000) x 100 = 9.33 %
Cap Rate Property B = (130,000/1,000,000) x 100 = 13%
What Do the Numbers Mean?
Which one – property A or property B – is the better option for the real estate investor? Is it better to have a higher or lower cap rate for someone who is looking to buy his/her next rental property? The answer is: The higher the cap rate of an investment property, the better the deal for the buyer/the real estate investor. This simply means that your new rental property will generate you more profit because of the selling price and the rental income. After all, the cap rate is inversely related to the price: the higher the price, the lower the cap rate, and vise versa. It is also directly related to the NOI, which depends on the rental income: the higher the rental income and the lower the running expenses, the higher the cap rate, and vice versa.
So as a real estate investor, you should always aim rental properties with as high a cap rate as possible. In the case above, property B is definitely the smarter real estate investment decision, based on the cap rate, all else kept equal.
However, these numbers are relative and should be assessed and compared with other cap rates in order to find the best real estate investment for you. While a cap rate of 10% can be excellent for a certain location, it might be pretty low for another location. Calculating the cap rate, as part of the process of investment property analysis, is an easy and quick way to compare many investment opportunities with one another.
Throw out the Calculators, No Need for Manual Work
Doing calculations manually is very time consuming and in this day and age, cap rates are readily found without the need for a good old calculator. If you sign up for Mashvisor, you gain easy access to the rental property calculator which will provide you with readily available cap rates for thousands of real estate properties across the US (as shown in the screenshot below). You find and compare the cap rate of each available income property to determine which investment opportunity reaps the highest returns. Furthermore, with Mashvisor’s analytical tool, you are provided with other key metrics to evaluate the rental property: from expected rental yield, through Airbnb occupancy rates, to cash-on-cash return (CoC) for single properties, neighborhoods, and city averages. While there is no magic formula for finding the best real estate investment, in this way you will have a much better assessment of the profit potential expected for any investment property you have in mind, which will eventually allow you to make better informed investment decisions. For real estate investors, make sure you are well aware of all valuation methods that can allow you to make better calls on your real estate investment portfolio or/and help you buy your first real estate property with confidence and ease.