Investing in real estate is one of the fastest ways to grow your wealth. Before purchasing an investment property though, you should determine its value.
One way to determine the value of a property, is to determine its capitalization rate as well as the going capitalization rate in the same area on a similar property. Real estate investors use the capitalization rate when determining whether or not to purchase a property. To obtain the capitalization rate of a property, you must take the net operating income of a property and divide it by the sales price.
Calculate the Cap Rate in 3 Simple Steps:
- First, determine the gross income of a property. You can do this by adding together all of the income sources such as the rent it brings in as well as any ancillary income from laundry services, etc. For example, let’s say the total annual income of the property we are considering is $100,000.
- Now that you have the gross income, you will need to subtract operating costs in order to find the property’s net operating income. This would take into account the real estate taxes, property insurance, landscaping, trash removal and other utilities the owner may be responsible for. In this case, let’s say it took $40,000 a year to operate the property. That would leave a total of $60,000 for your net operating income.
- Now you will need to divide that net operating income by the proposed sales price to reach the capitalization rate. Let’s say that the asking price for this property is currently sitting at $700,000. So if we divide the net operating income of $60,000 by the asking price, we would receive a capitalization rate of .086 or 8.6%.
Now that you know how to determine the capitalization rate of a property, you can use this math to see how this building compares to other similar properties in the area. If 8.6% is the going cap rate in the area but this property is sub-par compared to the other properties, then you may want a higher capitalization rate to make this property worth the investment. That means you would want a lower sales price. At $650,000 sales price the cap rate would be 9.2% which may make this investment worthwhile. On the flip side, if this property is pristine, you may be willing to accept a lower cap rate.
As you can see, determining the cap rate of an investment property is a very effective tool. As a real estate investor, having this math to back up your investment is crucial. Remember this formula for obtaining an accurate capitalization rate and you will find yourself becoming a real estate professional in no time!