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How to Use Cap Rates for Residential Investments

Welcome Back Investors!

Today we are going to get a bit technical for those of you who are bit a more advanced.
cap-rates-fetured
You may have heard the term “Cap Rate” thrown around at investor meetings and wondered what it is and how you could use it.  You probably then Googled it and found a bunch of information on commercial real estate investing and thought that it probably doesn’t apply to you.  Although it is primarily used in commercial real estate and multi-family units such as apartment buildings you can definitely utilize in your individual unit purchases with a few caveats.

First Off, The Basics
Cap Rate is short for capitalization rate and it basically determines the rate at which an investment yields a capital return to the investor.  As with most powerful things it is actually quick simple.

The formula is…

cap-rate-formulaSo the most important term to understand is Net Operating Income, which you must understand is your final income after deducting all of your expenses.  This is where many beginning investors make mistakes, they look at the amount of rent they will receive and subtract their basic expenses and then believe they will be making a ton of money.  Then they are confused when at the end of the year they have actually lost money.

Being a Sophisticated Investor Requires Diligence
Any good accountant will tell you that it is the nickels and dimes that will eat away at your bottom line.  So as a sophisticated investor you should be tracking all expenses, both recurring and one-time, in order to calculate your actual return.  This includes everything from service calls by plumbers and handymen to even the cost of sending certified letters on important notifications such as lease renewals.  But there is one other expense that even the most advanced may forget to include…

The Hidden Expense: Time
It takes a lot of time to manage a property effectively, there are always things that come up that require the managers attention. And if you are self-managing without a property management company you could find yourself spending hours and hours every month making sure problems are resolved.  So a good rule of thumb is to take what you make hourly in your regular job and then multiply that by the number of hours you spend a month managing your property.  Most investors make more than $30 an hour and since property management costs 10% of your gross income then you better make sure you are not actually losing money by trying to do things one your own.  There is a reason that major investment firms all use property managers, if they spent all their time managing properties they would never grow their business.

ben-time-is-money

So What is a Good Cap Rate?
In general a cap rate over 10% is considered a good return on your money.  So for example if you invest $100,000 and you earn $10,000 on that investment in a year it would be considered a good real estate investment.  But of course this is just a basic example and the real world is always much more complicated but 10% is a general rule.

Using Cap Rate to Make Investment Decisions
So it’s great to understand your return on a property you own at the end of the year but what about deciding to buy?  You have to do some estimating but even without getting too specific on minor expected expenses you can make a decision quickly.  If you see a property that is worth $200,000 and average rent in the area is around $1700 then you know it is not a good investment.  On the other hand if average rent is around $2,000 it might make sense and you should do a thorough analysis of the property.

Beware Amazing Cap Rates
Everyone has had that amazing deal come across their desks, probably a foreclosure, just needs a “little work” and what a price!  If a property costs $100,000 and average rent is $2,000 then the place is probably a dump in need of massive repairs!

We hope that gives you some better insight into your real estate decisions, if you have any questions regarding this concept please call us at 305-517-3900.  We can also save you a ton of time and aggravation with our rental market analysis and property management services.

See you next week!

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