To
understand the value of investment property you need to understand how
to calculate the “cap rate”. Not only does this give you a reliable way
of understanding your return on investment, it also gives you an apple
to apple method of determining the better rate of return between
multiple investment options.
Calculating the Capital Rate
The cap rate is a common ratio used by brokers, sellers, lenders, and other real estate professionals to assign a value to income producing property. The cap rate is derived from the income and expenses generated by the property along with the selling price. The basic formula is:
NOI is Net Operating Income.
Market Rate can be the seller’s asking price or your offering price.
Just
because a seller is making a monthly profit after paying the mortgage
and other expenses doesn’t mean you will. Likewise, the annual NOI isn’t
likely to remain the same under new management. You may be able to
reduce expenses or increase rents. Although the formula is easy to
calculate, the variables involved can be complex. Never take the
seller’s stated cap rate at face value. You MUST do your own cap rate
calculation.
The trick to determining an income property cap rate is having access to reliable gross income and operating costs.
Gross Income – Operating Expenses = Net Operating Income
Common
operating expenses for income property include employee salaries,
property taxes, maintenance & supplies, utilities, advertising,
insurance, and property management fees. They don’t include mortgage,
interest, broker commissions, or any costs paid to purchase the
property.
Make At Least Two NOI Calculations
However,
I suggest making at least two NOI calculations. One that includes the
mortgage and interest along with one that does not include the mortgage
and interest. The mortgage and interest is excluded in a traditional cap
rate calculation because these are variables that will change the
result. When a seller or broker quotes a cap rate, they have no way of
knowing what a buyer’s loan costs are going to be. As the buyer, you
want an apple to apple comparison of multiple investment properties and
the difference in mortgage and interest costs can skew this comparison.
These are the reasons that one calculation needs to be made excluding
the mortgage and interest numbers.
On
the other hand, investment properties are all about the bottom line
profit. Your mortgage and interest costs are expenses that come out of
gross income. Including these in the calculation is the only way of
accurately estimating the profit that the properties will produce.
The
cap rate is only the beginning of a thorough due diligence on an income
property and should never be solely relied on when making a purchase
decision. Financial calculations you want to perform include
cash-on-cash return, debt coverage ratio, and return on investment,
among others.
by Brian Kline
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Taken from: http://www.realtybiznews.com/residential-rental-valuations-the-right-approachRelated articles:
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