As an investor, your livelihood depends on making smart investments and getting the most out of them. And to accomplish this, you need a metric to evaluate how your real estate investments will perform from the point of your purchase, during your holding period and when you eventually sell it off to the next investor. This is where the cap rate comes in to offer you these bits of crucial information.
What is a Cap Rate?
Cap Rate – or better known as capitalization rate, is the rate of return you should expect from your real estate investment. In short, the cap rate of a property is what helps you predict the income you might receive from it.
Capitalization Rate = Net Operating Income / Purchase Price
The three main components of the capitalization rate are:
- Net Operating Income
- Capitalization Rate
- Property Value
The net operating is determined from the potential rental income you hope to gain from the property minus losses from vacancy, credit, and other expenses.
Why Do You Need to Know About Cap Rates as A Real Estate Investor?
Now, we’ll be looking at what makes cap rates important for a real estate investor. After reading through, you should have a good idea of cap rates and how they play into making smart investments.
1. Cap Rates Measure Investment Performance
During your initial purchase, calculating the cap rate of the property you purchase will give you a good idea of how it will perform as soon as you take over as the owner. Properties with lower cap rates will have a lower cash-on-cash return. Therefore, the cap rate is a good measure of investment performance in the short run for cash flow.
2. Cap Rates Determine Investment Value
Cap rates consider the purchase price and the net operating income of the property. With both these metrics at hand, you can make quick judgments on whether a property is worth investing into. Therefore, before you invest in a property, it’s worth looking into the cap rate to measure your return or yield over your holding period. If a similar property with a better cap rate is on your list, investing in that one will likely yield you a better investment value.
3. Disposition Cap Rate
Finally, you need to consider the disposition cap rate. This is crucial when you want to sell the property down the line and determine beforehand what the sales proceeds will look like. That is, if you project to hold a property for 2 years, you should divide the 3rd year’s net operating income by the projected market cap rate to determine how much the next investor is likely to pay for your property.
Cap rates are crucial in making smart real estate investments. In addition to predicting the future investment yields, they help you compare current good standing properties against each other to determine the best investment. Therefore, understanding and using cap rates when making investments is extremely important as a smart real estate investor.0