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How to Use Cap Rate to Find Good Investment Properties

How to Use Cap Rate to Find Good Investment Properties

Finding the right investment property is often a long and difficult process that requires analyzing property metrics and making an important financial decision. There are many ways to estimate the viability of buying an investment property, but sometimes investors can make wrong expectations about a particular property because they do not understand the implications of some values used to analyze the return on an investment property. Understanding how the property is financed, managed, and for how long it is held, may help gain more insight into what metrics to use to analyze the property. One of the most common approaches used to analyze a potential investment property is to calculate capitalization rate.

What Is Cap Rate?

The capitalization rate, which is also known as the Cap Rate, is a measure of the annual return an investment property generates relative to the total price of the property. For example, if a property costs $100,000, and the property generates $10,000 in net operating income annually, then the capitalization rate of this property is 10%. In other words, the cap rate represents a return on a property if it was bought with cash. This is a simple but important metric because it allows an investor to see how profitable the property is on its own. It is a base metric for return that does not account for leverage a real estate investor may have. 

Even though the capitalization rate is an important metric that real estate investors should look at, many real estate investments can be partially financed with debt, which may provide larger returns for an investment. Since the returns are affected by leverage, cap rate may not be the only useful metric to look at. The cost of financing also plays an important role, and some real estate investors may find themselves losing money on a real estate investment because of the financing costs. Understanding how and when to use a cap rate may help a real estate investor to make an accurate prediction on the return of an investment property.

When to Use Cap Rate?

The capitalization rate is an important metric for any investment property deal because it shows a return on the property that does not account for any financing, down payments or debt payments. This metric allows inventors to see how profitable the asset is on its own, which is very important regardless of the financing opportunities presented. If the cap rate is too low for an investor, then they may look for a better deal before looking for financing options.

Cap rate is always a useful metric, and it can be used solely by people who plan to purchase their investment property without financing. If a person does not get a mortgage to finance the property, then the cap rate may be an accurate measure of return an investor should expect from the property. On the other hand, if an investor takes a noticeable amount of leverage, then the investor should also look at other metrics that may provide a more clear outlook on the profit generation ability of the property.

Alternatives to Cap Rate

There is another important metric to consider when buying an investment property with a mortgage. Cash-on-Cash is a measure of return an investment property generates in cash relative to what the investor paid for it in cash. For example, if a property costs $100,000 and the investor puts down 20% for the property, the investor pays only $20,000 in cash. The property provides an annual net operating income of $10,000 and $6,000 goes towards mortgage payments. In this case, the investor receives $4,000 in cash and pays $20,000 in cash for the property, so their cash-on-cash return is 20% while their cap rate is still only 10%.

It is important to note that cash-on-cash can also be negative while the cap rate is positive. In that case, the investor will have to contribute money to the mortgage after rental income and operating expenses. Even though a negative cash-on-cash ratio does not mean that the property is losing money, many investors avoid properties that yield a negative cash-on-cash ratio.

What Is a Good Cap Rate?

Capitalization rate can also be viewed as a risk metric since traditional financial instruments follow the rule of the higher the risk the higher the return. Investment properties with overly optimistic cap rates may be a sign of hidden problems or missing information. On the other hand, properties with a low cap rate are considered safer, but not as desirable options. Capitalization rates also vary by city because different cities have different rental prospects and economic development projects. As a rule of thumb, reasonable cap rates range from 5% to 10%, but it does not mean that it is the best cap rate for everyone. Some people who are looking for high-yielding properties may choose to purchase an older property that requires renovation. This process may lead to a higher cap rate in the end because of the risks the investor took when they bought the property.

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