The capitalization rate is a way to measure the value of a real estate investments. It is similar to evaluating your rate of return on a stock, mutual fund or other investment – like an interest rate. To calculate the “cap rate”, determine your net annual operating income (usually rent, minus the expenses such as taxes, repairs, etc.). Then, divide the net operating income by the value of the property.
Over time, the value of a property changes. If the value goes up, there is additional value in the investment because when you sell, you should have already obtained an annual return on investment. Then, at the time of sale, you should generate some profit. In this sense, real estate is similar to a stock that pays dividends and appreciates in value. You can use the capitalization rate formula to determine if the real estate investment is still good over time because you can plug into the formula the new value, and get an updated rate. If the new rate is much lower than other competing investment opportunities, then it may be time to sell.
Real estate values tend to rise over time. It is difficult to predict values so the best strategy for most people is to find a good bargain, with cash flow. Cash flow is important because the investment should not cost you money over time. Only in rare cases would someone sustain a loss over time in the hopes of future profits.
Using a mortgage is a way to partner with a bank in an investment. But still, make sure you cash flow. Ensuring a net operating profit annually helps your own income but also ensures that when economic conditions decline, you can still hold the investment without damaging your personal income needs. Generally, after keeping a property for 30 years, you will you have gained income through the regular income, depreciating the asset on your taxes, and eventually selling the property. Over 30 years, the value gains can be quite surprising! For example, many houses in our area sold 30 years ago for the low $100Ks, and now sell for over $400K – and this is a modest example!
Don’t invest in real estate if your capitalization rate is less than the interest you would gain in a Certificate of Deposit, Mutual Fund, or other investments. Or for example, if an education would help you double your income, an education would likely be a better investment. If you own a business, and investment in your business would yield higher returns, consider that first. You should look at all the opportunities available to you before investing in real estate.
Currently, interest rates at banks, funds and rates of returns on many less aggressive investments are quite low. Real estate is a good place to invest historically. And it will continue to be!