Before you jump into real estate as an investment choice, you need to understand the capitalization rate concept. The capitalization rate (cap rate) tells you what your potential rate of return on your investment might be assuming you pay cash for the property. The cap rate can help you determine whether the property would be a good investment compared with other investment opportunities. This is a good opportunity to talk with your Synovus financial advisor to help you understand the pros and cons.
The higher the cap rate, the higher your rate of return. Just keep in mind that a high cap rate also typically indicates a greater risk. That's because higher cap rates are more common with cheaper properties, and cheaper properties usually involve a higher risk of not getting the entire rent payment each month and on time.
Most investors of rental properties are looking for a cap rate between 5% and 10%. Here's how to calculate the cap rate:
1. Calculate the property's annual net operating income (NOI). (This is your annual income minus all expenses — excluding the mortgage payment).
2. Divide the NOI by the home's purchase price.
3. Move the decimal two spaces to the right and add a percent sign. This is your cap rate.
If the home you're considering costs $300,000 and your NOI is $20,000, the calculation would be $20,000 divided by $300,000, giving you a cap rate of 6.7%.
If your cash flow is negative or if the cap rate is lower than what you could get by investing elsewhere, you might want to move onto another property where the numbers are more favorable.
Getting the right numbers
Doing the calculations for cash flow and cap rate is fairly straightforward. Choosing the right numbers to plug in requires some research. After you follow the above instructions for estimating rental income, here's how to get a handle on expenses:
- Ask your lender for an estimated monthly payment, or calculate your
monthly mortgage payment using an online mortgage calculator.
(You'll need to know what interest rate your bank is likely to give
- Find out the property taxes by looking up the home's address on an
online website like Zillow or asking the selling agent. Double-check
that this number is correct by confirming with the town's Tax
- Find out your homeowner's insurance premium by asking your
insurance agent for a quote.
Review the property's listing for any HOA fees.
Contact local property management companies for quotes if you
think you'll be using one.
- A behind the scene cost, at least for the first-time investor in real estate, is legal fees to have a lease developed..
By taking the time to track down the right numbers needed to figure your calculations and talking with your Synovus financial advisor about your specific investment goals, you can determine if investing in real estate is a good strategy for you.