When looking to buy a piece of property, one must determine exactly what
your expectations are for that bit of real estate. What mix of rent and real
property appreciation do you expect with this investment.? More importantly,
what is the right price to pay for this investment?
This last question is certainly the most important because it will
determine the difference between a good investment and a waste of money. If
you invest wisely and get a good price for a piece of property, you may
expect revenues of 18% and with capital gains in the hundreds of thousands.
Conversely, if you pay too much, you may end up paying into a losing
investment for the rest of your days.
Probably the most common, and therefore effective, method to value an
investment is through the use of a cap rate. Precisely defined, the cap rate
is the net operating income of the property divided by its purchase price.
It shows the expected percent annual return given a specific investment. The
benefit to using a cap rate is that a buyer can determine his or her
expected revenue from the investment, and define what a prospective
investment is worth. This effectively eliminates the random pricing of real
estate and reduces determination of the sales price to a simple investment
calculation. Instead of questioning whether an investment in a piece of
property is a good decision, a cap rate can be used to determine what the
expected return is, and if the investment will be profitable.
Another benefit of using cap rates to value property is in the resale
assumptions surrounding the investment. When you value a property as an
investment, you must assume that the person that will eventually purchase
that property from you will be looking for a similar return on their
investment. If you are purchasing an investment property and plan to hold
onto it for a fixed number of years, the cap rate can be used to determine
the resale value of the property in addition to your expected annual return.
As will all periodic costs, rents increase with inflation and local
demand. If you assume that the individual that will eventually purchase your
property is expecting a return on investment that is similar to your own
expectations, then the cap rate must be held constant. You expect a ten
percent return on investment (10% cap rate) so it would be prudent to expect
that the next buyer will also expect a ten percent return on investment. If
the cap rate is held constant, but the rents and subsequent net income are
increased, then the selling price of the property must also increase. By
assuming a growth rate in rents for a given holding period, you can
determine the resale value of your investment, and the magnitude of the
capital gains that you will realize from the sale.
Cap Rates are used widely in real estate because they provide a simple
method to determine a percent return on investment. From that, information,
investors and realtors can determine the proper pricing for an investment
given an expected return. They can determine the resale value of an
investment and any associated capital gains. Finally, cap rates can be used
to forecast to total expected returns on investment and confirm the proper
purchase price for an investment property.
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