Understanding Real Estate Cap Rates

Real estate investing is a big business. There are many factors to be considered when choosing which properties to invest in. One large consideration is the capitalization (or cap) rate. The cap rate is defined as the rate of return on an investment property based on the expected income that property will make. This rate is determined by dividing the proposed income a property will generate (taking costs into consideration) by the real value of the property. Let’s take a closer look.

Real Estate Cap Rate

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Income the Property Will Generate

Simple enough, this figure is the projected income the property will generate. Such as an apartment building will generate a fixed amount of income per unit multiplied by the number of units on the property.

Fixed Costs of the Property

Fixed costs include those costs which are predictable. This is the cost for electric and gas, water, lawn care, snow removal, and general upkeep. These costs can also be estimated based on the year-to-year costs, taking into consideration the inflation from year to year.

Variable Costs of the Property

This is the tricky variant. A water pipe can break and cause quite a bit of damage, causing the property not to generate any income while repairs are being made. A new roof can deeply cut into the profit margin. Broken appliances and natural disasters add to the list.

The Real Value of the Property

A property value can be determined through fair market appraisals.

Once these factors are considered and placed into the formula, a rate is generated. Using this method can help the investor decide if the investment that sounds so good can actually make money. While no formula is iron-clad, knowing what you are getting into before making the investment helps the investor make an informed decision.