What is Capitalization Rate in Real Estate
Understanding specific real estate-related terms can help your career as a real estate investor. Capitalization rate (also known as cap rate) is an important term to understand if you have long-term investments because it is one way to measure the potential return on investment (ROI).
Given its focus on long-term investments, you might wonder how cap rate is relevant to you as a fix and flipper. Some investors purchase property, fix it, and then refinance it to keep it as a rental property. This may be a beneficial long term investment in growing real estate markets.
You shouldn’t consider cap rate as the only piece of information to use because it doesn’t factor in changing property values. Cap rate is best used as additional information for a possible investment alongside other factors like operating costs, taxes, and property value.
Long term investments are an option after a fix
Diversifying your real estate portfolio is always a great idea. A long term investment can supplement your portfolio alongside fix and flip investments. Capitalization rate will definitely help when making the initial property selections, but remember that they’re used as a general guide and should be supplemented by other data.
Calculating cap rate
You can calculate cap rate by dividing net operating income by the original cost of a property.
Net operating income is the annual income earned after any operating costs are deducted. So if a property earns $50,000 a year, but has $15,000 in operating costs, the net operating income is $35,000 a year.
To find out your cap rate, you take your net operating income and divide it by the original cost of a property or its market value.
For example, you bought a property for $250,000. The net operating costs are $25,000.
25,000 / 250,000 = 0.1 or 10%.
This means that every year, 10% of the property costs are paid and the investment should pay for itself in 10 years.
If you’re looking at a long term investment, 10 years for the investment to pay itself off might be good. But if you’re looking for shorter term gains, you can make the decision to keep the property for a couple years and then sell it.
Why is cap rate important?
You can’t buy property just because the price is low. You also have to look at home sales in the area. Is there a reason that the price is so low? That price might be a good deal for a fix and flip, but may not make sense for a longer term investment. Use cap rate to compare different homes and determine the best value homes that work as refinance property.
To figure out the best value home with cap rate, select similar properties in the same area. These homes must be the same property type. Also look for valuations that were completed around the same time. This will ensure that the property values are comparable. It wouldn’t make sense to compare cap rates for property with a 2016 valuation when it’s 2017.
When to use cap rate
Cap rate is a great tool, but it isn’t a 100% accurate number for investment gains. It gives you a general idea of when an investment pays off, but the equation only considers an unchanging net operating income and property value.
The cap rate should be used as one of the factors for a real estate investment, but never the only one. Other factors like location, property type, and market growth should be considered.
Cap rate also isn’t good for valuing short-term investments because, in these cases, the property isn’t kept for an extended period of time. Varying property values will have an effect, especially if the property was gained through zero cost like a gift or inheritance. When applying the cap rate equation with a $0 cost, the result is undefined because you’re dividing your net operating income by $0. You didn’t have incur a cost for the property so the investment is paid off.
If you’re looking to find the property’s market value, you can find a general value by comparing your property to other similar properties in the area. Consider property square footage, amenities, and bedrooms and bathrooms and compare the similarities and differences with other property. It won’t be a 100% true value, but an estimate. To get a true property value, you will need to get a professional appraisal.
A post-fix property can be a great long term investment
After you’ve put the time and money into a fix and flip, your first plan is to sell it as soon as possible to pay off the bridge loan and put those profits back into another property. Another option is refinancing it and pursuing a longer investment. This is a great option if you’re looking to diversify your real estate portfolio.
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