Real Estate Investing - Capitalization Rate
A method Real Estate Investors use to evaluate Investment Properties is the Capitalization Rate.
This is a very basic easy to use tool, but you need to have a good idea about what your Net Operating Income will be. The Capitalization Rate is very simple: You divide the Net Operating Income by the Asking Price:
Net Operating Income/Asking Price = Capitalization Rate
So if one of your Investment Properties has a projected Net Operating Income of $13,700 with an Asking Price of $200,000.00 for a piece of property the Capitalization Rate is 6.85%.
$13,700.00/$200,000.00 = 6.85%
The Real Estate Investor needs to know what the Market Capitalization Rate is in the local market to compare potential Investment Properties. This information may not be readily available and rents may really vary in a market. The Real Estate Investor should have an idea as to what Capitalization Rate they want to achieve.
However, if a Real Estate Investor has a particular Capitalization Rate in mind you may also use the Capitalization Rate as a way to determining the price to pay for Investment Properties. Simply reverse the formula.
Divide the Net Operating Income by the desired Capitalization Rate to find a Maximum Offering Price:
Net Operating Income/Desired Capitalization Rate = Maximum Offering Price
Taking our example above: A Real Estate Investor feels he needs to achieve a 7% Capitalization Rate and the Net Operating Income is $13,700.00 for one of his potential Investment Properties.
$13,700.00/7% = $195,417.29
The Maximum Price the buyer would want to offer is $195,417.29.
Most Real Estate Investors would feel the higher the Capitalization Rate the more profit potential for Investment Properties. The Capitalization Rate is very popular with Real Estate Investors looking at Investment Properties I do not think it is the best method.
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