Beyond Curb Appeal:
How to Evaluate a Rental Property
Understand "Capitalization Rate"
One of the easiest ways to evaluate a rental property's performance is to look at its Capitalization Rate (often referred to as the "Cap Rate".)
The Cap Rate measures the return you can expect on your investment. The higher the Cap Rate, the better the rate of return.
How to Calculate Cap Rate
To determine the Cap Rate, divide the yearly net operating income by the price of the property.
(If the property is not for sale, use estimated market value instead of price.)
For example: If a property's net operating income is $36,000 and the property is priced at $360,000, the Cap Rate is 10%.
Evaluating a Property Using Cap Rate
Looking at Cap Rates instead of list prices when comparing rental properties allows us to focus on the rate of return.
Example: Two very similar rental homes are for sale in the same neighborhood.
Property A:
Costs $450,000 and has a net operating income of $31,000.
--> Cap Rate = 6.89%. ($31,000 divided by $450,000.)
Property B:
Costs $480,000 and has a net operating income of $35,000.
--> Cap Rate = 7.29%. ($35,000 divided by $480,000.)
Property B costs more than Property A, but B's higher Cap Rate shows that it's the better deal.
Tip: In order to truly evaluate the investment scenario, you'd want to know what typical Cap Rates are in that area. If it's common to see an 8% Cap Rate, that means both Property A and B might be overpriced.
Note: A low Cap Rate may also be due to below-market rents.
If rents are due for an increase, calculate a new net operating income using updated rent values to come up with a realistic Cap Rate.
What's the Right Cap Rate?
It depends on the property's location. In some areas 4% may be the norm, while in other places investors look for double digits.
The goal when determining market value is to know what Cap Rate is reasonable for the area in which you're buying.
What Is Gross Rent Multiplier?
Gross Rent Multiplier (GRM) is another method investors use to analyze investment properties. However, GRM uses Gross Revenue rather than Net Operating Income, which makes it less helpful in determining the true rate of return.
Remember the Big Picture
Cap Rate is just part of the scenario. Anticipated property appreciation, trends in monthly rent, and a realistic expectation of future maintenance, repair, and vacancy costs are other key considerations.
Tip: Double-check any Cap Rates provided to you. It's surprising how often a Cap Rate for a listed property turns out to be incorrect.
Did You Know?
1. A rental sale may be exempt from capital gains tax.
If you used the property as your primary residence for 24 months during the five years prior to the sale, it probably qualifies for the home sale tax exclusion.
Note: As a seller, you are
not required to invest the proceeds in more real estate within two years in order to avoid capital gains tax. Many people believe this to be the case, but that law was changed in 1997.
2. A 1031 exchange allows you to defer capital gains taxes.
A 1031 exchange procedure allows you to defer capital gains taxes when you sell an investment property and you use the funds to buy another one that's similar in type and value. A third-party person or company called a Qualified Intermediary facilitates the exchange and ensures that timing requirements are met.
3. DSCR loans are based on a property's rental income.
A Debt Service Coverage Ratio loan is granted primarily based on whether or not a property's rental income will be enough to cover the mortgage. Rates are typically higher on these loans, but they make it easier for investors to buy an ongoing succession of rental properties.
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