Let’s assume that you have put some money aside and have decided to purchase your first investment property. You’re ready to jump in with both feet and start building long-term wealth but you’re paralyzed by your options. How do you decide which is the best investment? Well, when it comes to investment properties, two key factors will influence your ROI: cash flow and projected resale value. Cash flow is the profit you make while holding onto your investment and is easily calculated by subtracting your overhead costs from the rent. The second factor is (ideally) the profit you make when you sell the property and is based on projected resale value. While we can make educated predictions based on the past, even real estate moguls can’t predict with absolute certainty how the market will perform 5, 10, or 20 years from now. That’s where the risk comes into play, but there are a few calculations that can minimize this risk and help you spot that diamond in the rough. I’m about to share the quick and dirty calculation I personally use to compare investment properties — and it’s easier than you may think.
Before we jump into the calculation, it’s important to understand how properties are valued in the first place. Most property values are based on market comparables, which are other properties in the same area with similar factors. For instance, if you’re buying a three-bedroom, two-bathroom detached house, you’ll want to look at the price points of other three-bedroom, two-bathroom houses in your area. Then, to determine the value of your property, it’s simply a matter of averaging out the prices of those market comparables. If you’re interested in a more detailed account of how these values are determined, check out ‘How Appraisers Determine a Property’s Value’.
Although these market values are an important consideration for investors, they fail to account for the potential rental income that can be made along the way. When we take this into account, we can value the property in a new way and more easily compare investment properties to one another.
Using the Cap Rate to Compare Properties
The cap rate is a simple yet powerful formula that determines a property’s annual rate of return, which allows investors to predict how much money a property will generate in a given year. It’s important to understand that this number is very different than your return as it does not take into account factors such as The Power of Leverage and Time Value of Money, which we’ll get into another time.
For now, let’s dive into the calculation:
The Net Operating Income (NOI) can be calculated by adding up the income that the property earns in a year (primarily rent) and subtracting out operating expenses (such as condo fees and property tax). Once you’ve calculated your NOI, simply divide it by the current market value and you have your cap rate.
Let’s use an example to demonstrate how we can use the cap rate to compare two properties.
Property 1
The first property you are looking into purchasing is owner-occupied and listed for $145,000. You know that your expenses will average out to approximately $220/month and that similar homes in the area are renting out for $950/month. Now, before we go any further it’s important to assume that your property will be vacant for 15 days each year to account for repair time and/or time between leases. If you get lucky and end up leasing to the same tenant, then these extra 15 days of rent are just icing on the cake!
Okay back to the calculation. Based on the above factors, you can determine your annual costs as follows:
Annual Income: $950 x 11.5* = $10,925
Annual Expenses: $220 x 12 = $2,640
NOI: $10,925 — $2,640 = $8,285
*Remember we are accounting for 15 days of vacancy
This gives you a cap rate of 5.71%.
Property 2
On the other side of town, you’ve found a newer property that’s listed for $285,000. Since it’s one of the nicest properties on the block, you feel confident that you can rent it for more than the market comps that are renting for $1,100. But you don’t want to price it too high and risk it sitting vacant, so you settle on a monthly rent of $1,200. You then calculate that your monthly expenses will be $300. Again, we’re going to include the same vacancy assumption of 15 days.
Now, let’s use the same equation to determine whether the higher rental income will be worth the extra purchase price!
Annual Income: $1,200 x 11.5 = $13,800
Annual Expenses: $300 x 12 = $3,600
NOI: $13,800 – $3,600 = $10,200
As you can see from the calculation, the cap rate is only 3.58%, so in this instance, the higher rent won’t make up for the higher purchase price, but that doesn’t mean you can’t make it work.
If you remember way back to algebra class, you know that you can manipulate the equation to figure out a purchase price that will provide the same yield as the first property. To do this, divide the NOI by the cap rate of Property 1, as follows:
The equation shows that you would need to buy the second property for $178,633.98, (37% below its market value) to yield the same ROI. So, unless you believe the second property is in an area where you could increase the NOI quickly (by increasing rent), then the first property is the better investment opportunity.
Understandably, it can feel a bit daunting to put your deposit down and sign on the dotted line. My hope is that by having this little calculation in your back pocket, you’ll be able to compare your options and confidently move forward in your decision-making process.
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