CAPITALIZATION RATE - INVESTING IN PROPERTIES

People are often confused about investing in real estate for investment purposes. When I am speaking of "investment purposes", I am talking about a long term investment where the subject property is a rental property. People know if the mortgage payment per month is $600.00 and the rent is $800.00, they are making money. Or are they?

The best way to analyze a property's potential is to use the income approach and the capitalization rate. What is it? It is how the property will pay for itself or cash flow. Often you will hear people talk about "cap rate". Again, what is it? It is a measure of how fast an investment will pay for itself. Thus, if your "cap rate" is 10% , the investment will pay for itself in ten years. And again, if the cap rate is 5%, the investment will pay for itself in 20 years.

How do you calculate the "cap rate"? It is a ratio between the net income and the price or cost of the asset. So, how do you calculate net income? The example below will give you an idea of how this calculation works. I will use a $1000 rent for the example. I am also assuming this is a 1200 square foot, single family house.

Gross Income (Rents x 12) $12,000
Real Estate Taxes $ 1,000
Utilities (Paid by landlord) $ 500 (Assuming in Philadelphia landlord is paying Water and Sewer - typical)
Insurance $ 1,000
Management Fees $ 720 (6% - could be higher)
Maintenance & Repair $ 600 ($0.50/ft - using 1200 square feet)
Replacement Reserves $ 420 ($0.35/ft - using 1200 square feet)
Snow Removal & Misc $ 400 (estimated)
Vacancy & Collection $ 600 (5%)

Net Income $ 6,760


Now you know what your net income looks like. However, some of these expenses listed above could be different in reality. For example, management fees could be more. In Philadelphia, it is likely that the insurance and taxes could be lower. Also, I have built into this formula that the property is in good condition when rented. I am assuming the roof, systems, kitchen and bathroom are reasonably up to date and functioning.

Now, you need to address the Capital Cost or Asset Price. See the example below.

Purchase price $60,000
Closing Costs $ 4,500 (7.5% - Philadelphia typically 6-9%)
Improvements $10,000 (Estimated)
Asset Price $74,500

The next step would be to take a look at the ratio.

Net Income/Capital Cost = Capitalization Rate

$6,760/$74,500 = 9.07%

Thus, the investment would pay itself off in a little more than 11 years. This is a very good capitalization rate.

Conversely, you may be looking at properties where you know the price. You can quickly calculate a number on gross figures to know whether it is worth even looking any further. I am seeing a lot of properties, currently, that are multi-family. They are collecting, let us say for this example, about $1800/month and asking $500,000 for the building. So, if I want an 6% cap rate, I don't have to go through great calculations to see what is what.

Gross Income/Capital Cost = Cap Rate

$21,600/$500,000 = 4.32%

STOP HERE! We have not used the net income nor have we added closing costs and improvements, and we are at a 4.32% Capitalization Rate. When we add and subtract the rest, the rate will only go down.

If you want to see what you should pay, let us assume that there are 3 units each paying $600 per month. Let us also assume that the building is 2000 square feet.

Gross Income (Rents x 12) $21,600
Real Estate Taxes $ 1,200
Utilities (Paid by landlord) $ 1,000 (Assuming in Philadelphia landlord is paying Water and Sewer - typical)
Insurance $ 1,200
Management Fees $ 1,296 (6% - could be higher)
Maintenance & Repair $ 1,000 ($0.50/ft - using 1200 square feet)
Replacement Reserves $ 700 ($0.35/ft - using 1200 square feet)
Snow Removal & Misc $ 400 (estimated)
Vacancy & Collection $ 1,800 (5%)

Net Income $13,004

So, if our net income is $13,004 and we want an 6% cap rate, which is the average for apartments, what should we pay for the asset?

Net Income/Cap Rate = Cost of Asset (What should be paid including closing cost and improvements)

$13,004/6% = $216,733

If you are trying to achieve a higher cap rate, be aware that many properties allowing for higher cap rates, will usually have higher vacancy rates.

Now, of course, there are other factors to consider when purchasing the property. Will the rents increase? Will the expenses increase? I could go on and on, but the questions may blur the idea of what I have explained herein. Thus, when considering purchasing and investment property, consider how the property will cash flow to see if you are making a good investment or not.