This post is a continuation of Chapter 3 from the book, Empower Your Inner Millionaire, A Woman's Guide to Financial Independence through Real Estate Investing, available from Chris and on Amazon.com
Cap Rate
The capitalization or cap rate is the net amount of income that the property generates divided by the cost. If a property is selling for a million dollars and it generates $100,000 after expenses, 100,000/1,000,000 = .10 or 10%. The higher the cap rate, the more bang for your buck. The cap rate should give you an idea of the risk. By comparing similar properties in comparable locations, you would expect that the one with the higher cap rate would have some variable–the age of the property, for example–that makes that purchase riskier. Don’t assume that one seller has just priced her property too low. Although that could be true, look for the variable that supports the difference in cap rates. If there isn’t one, then you’ve probably found a great deal!
You should also be considering future potential. When comparing cap rates, it may make sense to do two calculations. One using market rents and one using the rents that are currently being charged. That way you won’t miss out on a great deal just because the owner is charging low rents. Be sure that you understand what investment is needed to get market rent in the building. Sometimes it’s just a coat of paint, sometimes you’ll need to update kitchens or baths or add air conditioning, for example. Add that expense to the cost of the property in your cap rate calculation.
Appreciation Rate
The concept that you make your money when buying a property is especially true when you’re hoping to sell fairly soon after buying. If you’re planning to hold for ten years or more, the market cycle shouldn’t matter much beyond saving money every month when you make your mortgage payment. Getting an idea of what you can expect for appreciation will help you compare the potential future value of a property. Remember, your goal is to compare two or more potential investments, so your analysis is more the difference in expected appreciation between your various options. Does the potential of one location exceed the potential of another? Is one type of property–commercial vs residential–expected to fare better in the area?
Even if you plan to keep the asset forever, future value is important as your plans may change unexpectedly or you may want to take out a loan or line-of-credit on the property. Your real estate agent can help you understand past trends and how they relate to future appreciation or you can use online resources like tax assessments to get a rough idea of the market cycle in the area. See EYIMBook.com for more information on this type of research.
Overall Rate of Return
Understanding the potential future value can help make a property with a lower cap rate more attractive than one with a higher rate. Adding the Cap Rate to the Appreciation Rate will give you the Overall Rate of Return for a longer-term look at the investment. For example, you are comparing a restaurant in Georgetown with an apartment building on the same street. The Cap Rates are both 5% but you see a trend of similar apartment buildings being converted to condos. The appreciation rate on the apartment/condos would be 10% while the restaurant would increase at the area average of 3%, making the apartment building a better investment, 15% for the apartment building versus 8% for the restaurant.
Leverage
If you’re having a lot of fun with this math stuff, you can take it one step further to figure out whether it makes more sense to leverage the property or buy with cash–or rather whether it makes sense to buy the property if you can’t pay cash. Doing this is easy, just subtract the interest rate you’d pay from the overall rate of return. If the number is negative, don’t do it. You’ll lose more on interest than you’ll gain in the short term. You’ll find spreadsheets with this and other helpful formulas on EYIMBook.com.
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