What’s a Real Estate investor to use?
The different methods available for calculating a good investment can be mind-boggling. You can spend days or weeks, reading books & blogs on the advantages, disadvantages and differences, on a slew of projection calculations. We’ll take a brief look at the top three formulas used in the industry.
The Capitalization Rate or “Cap Rate” is usually only used in Commercial property application, because you can fairly easily calculate the Net Operating Income or “NOI“. Expenses are fairly constant in commercial applications as opposed to residential. However, I do have residential investors who use it. The formula to figure a Cap Rate is; Net annual income divided by purchase price or [(monthly income x 12) – (annual expenses) / purchase price]. Example; Suppose you purchase a property for $500,000. And suppose your net operating income, after operating expenses but before any interest, principle or depreciation, is $50,000. Your Cap Rate is 10%, i.e., 50,000/500,000.
So whats a good Cap Rate? That’s the million dollar question. The Market Cap Rate, for Single Family Residential properties, here in North Orange County California, is currently about 5-6%. You may read blogs from people who are fine with 4% and those who won’t buy unless the get 10% (they’re waiting for a MUCH better market). A good rule of thumb is; As long as your Cap Rate is higher than your borrowing cost (interest rate), then you should borrow as much as possible with respect to the acquisition and/or holding of that property. However, if your Cap Rate is less than your borrowing cost, then you should either pay cash for the property or find a different property to buy.
Now the “Cash-on-Cash Return” rate is different. It is used for calculating your cash income on your cash investment. It would measure the annual return you make on a property in relation to the down payment. You take the property’s annual net cash flow and divided by your net investment, expressed as a percentage. Example; The net cash flow from a property is $10,000 (annually), the cash invested in the property (or down payment) was $100,000, then the Cash on Cash return is calculated to be 10% ($10,000/$100,000). Another way to look at this ratio is by comparing it to a return of a certificate of deposit. You deposit money in the bank and the bank pays you an annual return, say 5%. That 5% is the Cash on Cash ratio. Cash on Cash returns do not include property appreciation. If you are evaluating a property on a long-term basis, you need to focus more on the annual cash flow as it relates to your investment, and focus less on property appreciation.
For those interested in a short-term Rate of Return or “ROR” (no more than 5-7 years) you want to look at the appreciation of the property. National averages range from 3 1/2 % to 4 1/2 % conservatively. They can exceed 10 – 12% in an extremely good year. Here’s what it could look like; say you have steady tenancy for the duration of a 5 year period and we’ll look at a conservative stance for this example (income matching expenditures and 4% annual appreciation). You buy a property Today for $500,000, with a $100,000 down payment…in 5 years time that property is worth $608,326, which is a 108% return on your $100,000 investment.
In an economy like the current one, coupled with the historically low-interest rates, those with a great sense of business and investments, turn to Real Estate. As always, we highly recommend that you speak to your financial advisor before making any major decision with you families future. However, here is a handy online calculator that may help you get started; http://www.calcxml.com/calculators/inv04
An experienced Real Estate Consultant/Negotiator (like Scott Stephens) can also be a valuable tool in maximizing your invest returns.
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