What is a Cap Rate?
In last week’s video, I shared with you the best property to invest in, the duplex. But why a duplex? And more importantly, why invest in real estate at all? Well, for the amazing returns that you can achieve, and the wealth that can be made.
But how do you know if the property you’re looking to invest in is going to make a good return. Well stay tuned to find out.
In today’s video, I’m going to talking about 2 financial calculations you can use to determine if the property you are looking to purchase will produce high returns.
And they are the cap rate and the cash on cash return financial calculation.
Now, I did touch on these in an earlier video, this one here, the 5 Financial Calculation I use. However, today I want to go more in depth and how they can be used, because the best part about these calculations is they tell you how much money you’ll put in your pocket.
So let’s continue.
As I said in my last video, I love investing in duplexes. This is because they are great at produce monthly cash flow, that is, putting money in your pocket.
Please note, this is not all duplexes, as in higher priced markets, which I don’t invest in, as I only invest in affordable markets, many properties don’t even cash flow, resulting in a negative cap rate, and negative cash on cash returns.
However, in the example I’ll be going through which is actually one of my duplexes I own, located in an affordable market, windsor on, the property cash flows very well, even if you were to purchase it today
So, let’s look at my duplex, which I showed you in my last video that I own, the side by side.
I actually bought this property back in 2013 for only 87K, however, today, its worth much more, which we are actually going to determine, by using the approximate cap rate in my market.
First, we need to determine the NOI. To do this, we will take the rental income the property generates, which, currently my duplex rents for $1000 per unit, for a total of 2000 per month, less the properties expenses.
Remember, the mortgage payment is not included in the expenses when figuring out the capitlization rate because this calculation determines your return if you were to purchase the property all cash. This why many investors like this calculation because they can then compare it to the return a mutual fund, or stock would get, and decide which is the better investment.
Back to the expenses, currently my duplex incurs approximately about 700 per month. This includes water, taxes, insurance, management, misc and repairs. Note, I don’t pay any of the utilities at this property, as the tenant pays electricity and gas.
Once we subtract our expenses from our income, my duplex has a NOI 1300 a month.
We then multiply the monthly NOI by 12 and divide by the purchase price.
But, we don’t know the purchase price.
Not to worry, we can use comparable properties that are available or have sold recently in the area to determine this. Or, and what many investors do when buying income properties, they will use the market’s capitalization rate.
To determine this, you need to know this for your market.
As an example, for my market, when I began investing, investors wanted a 10 cap. Today, investors purchasing in my market are looking for anywhere between a 5-7 cap, depending on the market and the type of property. It is now lower, because there is less risk now in my market and properties are appreciating.
When the risk is higher, and like my market back in 2013, there is no appreciation, you are going to want a higher cap rate from the properties your investing in. So if you aren’t getting it from appreciation, you better get it from the income the property generates, hence the higher cap rates.
Anyways, for our example, we are going to use a 7% capitalization rate to determine the value of the property.
To do this, we take the annual NOI and divide the cap rate. As you can see here, this tells us the property is worth 211K.
Now this was a great way in figuring out the value of the property, however, what if I already know the value of the property, and I want to determine the return it will generate based on the price of the property?
To do this, we would take the properties NOI, and divide it by the purchase price. So let’s assume that I sold my property for $250K, well at that price, it results in a 5.93% cap rate as you can see here.
This is why cap rates are a great, because they can quickly help you determine the return the property will produce as well as it can help you determine the price of the property. Remember, the higher the cap rate, the higher the return, meaning, the more money in your pocket now.
However, what happens when you finance the property? Which is the best part about investing in real estate versus stocks, as you can leverage the investment, by using other people’s money, such as a bank’s money, to help finance the purchase. When purchasing a stock, you can’t do this, well you can but it’s more difficult and you need a lot of capital.
Well the cap rate is no good because this calculation takes into consideration the return if you bought the property all cash.
Not to worry, as this is where the cash on cash return financial calculation comes in, because it tells you the return you’d make based on the money you invested. And since you know it is wise to finance the purchase of real estate, because it minimizes the money your investing, the result is a much higher return.
This is why the cash on cash return is a great financial calculation to use if you are going to be financing the property, as it gives you a more accurate overall picture in determining the actual return on your investment
If the investor whom purchased my property for $250K were to put a down payment of only 20%, then, as you can see here, the duplex produces a cash on cash return of 6.56%.
Remember, when calculating the cash on cash return, you will need to now include the mortgage payment as part of the expenses to determine your NOI.
Now, there is still one more factor you should consider when investing in real estate, to help you fully analyze the return the property will generate, which I will be talking about in my next video. WHAT TO DO NEXT: Enroll in Real Estate Investing Bootcamp
So check back next week to find out what that is and how it will help you invest in the property that produces the greatest return.