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Real Estate Investing – Understanding Capitalization Rate

Have you ever wondering how to compare investment properties when there are several to choose from? There is a little known secret that Real Estate Investors, Lenders, and appraisers use for understanding the return rate from a home, and value of a home compared to other similar homes.  The solution is to use something called the capitalization rate. The Capitalization rate is simply the Net Operating Income (NOI) divided by the market value or purchase price of the property.

Cap Rate = NOI/Purchase Price
NOI = Expenses required to maintain the property per year (excluding debt)

To calculate your NOI, you add up all expenses needed to maintain the home for one year.  This does not include debt payments, such as a mortgage payment.  The reason is that the comparison between properties needs to be a like comparison, so the cap rate is calculated as if the home was purchased with cash to understand the rate of return the property provides.

Notice something else interesting about the Cap Rate formula.  By using the inverse of the Cap Rate formula, you can calculate what the purchase price is for a home in the same area as other homes that you have a cap rate for.

Purchase Price = NOI/Cap Rate

For example, if you found the cap rate of surrounding homes which sold already to be around 6%, you would just calculate the estimated amount of yearly NOI required to maintain the property you are interested in, and then divide the NOI by the 6%.  This will give you the value of what you should pay to purchase the investment property.

As you can see, by simply using a Cap Rate equation, it is simple to compare investment property options.  Generally you want to look for investment properties that produce a 5% – 8% Cap Rate.  Whether you are close to the 5% point or 8% point depends on the geographic location of the property.

Be sure to check out the article on Investment Property Loans and how to get the best rate.

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