Using Cap Rate to Calculate the Purchase Price For an Investment Property
Using Cap Rate to Calculate the Purchase Price for an Investment Property:
CAP Rate is a ratio used to determine the return on an investment producing property. A good way to look at CAP Rate is to assume that you are purchasing the property in full with cash. You want to know what will be the return on my investment. You want to see if the investment property is a worthwhile investment. If your CAP Rate is equal to 3%, you may be better off investing elsewhere. If your CAP rate is 7%, you are also getting a tax write off, and the property appreciates, this may be a good investment for you.
CAP rate is calculated by dividing your annual Net Operating Income by the Purchase Price of the property. As an example, if your Net Operating Income is $10,000 and your purchase price is $100,000, than your CAP rate would be 10%:
CAP RATE = ($10,000 / $100,000) X 100% = 10% CAP rate
The Net Operating Income is probably the biggest part of the equation. You will need to take into account all expenses that you will be responsible for paying throughout the year, such as: taxes, insurance, heat, electric, water, sewer, trash, heater maintenance, miscellaneous maintenance, and any other expenses that will be required for your property.
You can determine your final sales price on a property by calculating CAP rates for similar investment properties that have sold in the area. By calculating the CAP rates for similar properties in the area, you will come up with a range of CAP rates that you will want for your property. Similar properties that are in better shape will have a lower CAP rate, since they will need less maintenance. Properties that need more work will have a higher CAP rate, because they will have a higher annual maintenance cost each year. If you see that comparable properties produce CAP rates between 8 and 10%, then you will see that this will be the range for your sales price.
High risk properties (where tenants may not worry about the property condition up or paying their rent on time) will demand a higher cap rate. You will expect to get a larger return on your money, because you are taking more of a chance. Landlords should have an extensive screening process to reduce their risk in these areas, and return good profits.
Lower risk properties (where tenants keep the home and neighborhood in good shape, and are reliable in paying the rent) will produce a lower CAP rate, since there is lower risk. Properties in these areas will normally appreciate more than in the higher risk areas.
See the example below:
Property: 123 Main St - DUPLEX
Asking Price: $150,000
Monthly Rent - Unit 1: $800/mo
Monthly Rent - Unit 2: $700/mo
Desired CAP Rate 10%
(Calculated from Neighborhood comps)
Home Owner's Insurance: $700/yr.
Heat: Tenants Pay Heat
Electric: Tenants Pay Electric
Water and Sewer: $800/yr.
Heater Maintenance: $150/yr
Misc Yrly. Maintenance: $1,000/yr.
Total Yearly Expenses: $5,000
Yearly Gross Income = (12 months) X ($800/mo + $700/mo) = $18,000
Yearly Net Income = (Yearly Gross Income) - (Total Yearly Expenses)
Yearly Net Income = ($18,000) - ($5,000) = $13,000
If you would like a desired CAP rate of 10%, you can calculate your purchase price by:
Purchase Price = (Yearly Net Income) / (CAP Rate / 100%)
Purchase Price = ($13,000) / (10%/100%) = $130,000
CAP rate is a quick way to determine if a property is a good investment. There are more extensive approaches to calculating an investment, which take into account appreciation and tax advantages.
Pat Egan is the Broker and Owner of Egan Real Estate in Ardmore, Pennsylvania. Pat has been investing in real estate since 1993. He grew up in construction, and has a good basic understanding of what is needed to make a property work as an investment. Pat has a degree in Electrical Engineering, which he practiced for 6 years. Pat has been helping people buy and sell real estate since 2003. His engineering background helps when analyzing properties for his clients. Please feel free to contact Pat with any questions at firstname.lastname@example.org.
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