Thursday, November 09, 2006

Investment Property, It's all about Income and Cap Rates

My dissertation on Cap Rates. I wrote this some time ago, but was too lazy to grab onto anything new. Maybe I'm just overwhelmed from the news of Ed Bradely and the election banter on talk radio. I'll look for more interesting topics at a later date, but for those of you that own income property, enjoy...

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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