Breaking Down The Basics: Cap Rates

For months I’ve been telling you how now is a fantastic time to be a real estate investor in Des Moines. I’m guessing that since you’re here, I’ve at least managed to convince you to consider putting your money to work for you with a real estate portfolio. Of course, I don’t want you to just go into this blindly, I want to make sure you have all of the information you need to maximize your profits. So, today I’m breaking down one of the most important lessons you will learn as a Des Moines real estate investor.

What Is A Cap Rate?

“Cap rates”, short for capitalization rates, is what a real estate investor uses to try and determine what the rate of return will be on a given property. It is based on what you could reasonably expect for a net profit from your investment. Although it isn’t completely concrete, it is a strong differentiator to help you separate a wise investment from a foolish one. In fact, it is the most commonly used and respected method used by real estate investors to select their properties.

The Capitalization Rate Formula

Calculating a cap rate is a case of there being more than one way to skin a cat. In the most popular method of calculating it, you will divide the property’s net operating income (NOI) by the property’s current market value.

Net Operating Income / Current Market Value = The Capitalization Rate

In order to identify the net operating income, you will simply subtract all of the expenses associated with the property from the revenue that it brings in. Let’s say you have an apartment building in downtown Des Moines. You would find the NOI by subtracting expenses like taxes and repairs from the rental income.

In a far less popular version of the cap rate formula, you would divide the NOI by the property’s purchase price rather than the current market value. This method is less popular because it is less reliable. For starters, purchase prices are impacted by previous transfers of the property that occurred during years or decades when prices were bottom barrel. In other cases, the property was inherited which means there is no purchase price to use.

Application of Capitalization Rates

Let’s say that you have $1 million to invest as a newbie investor. Obviously, you’re going to want to select the safest possible option to protect your money, as well as, grow it. You’re trying to decide between a government issued treasury bond which will give you 3% interest annually and a multi-unit commercial building downtown filled with reliable tenants. Now let’s assume that the annual rent from those trusty tenants is $90,000 and the combined annual expenses on the building are $20,000. This means that the NOI on the building is $70,000. Finally, let’s also assume that the purchase consumes your entire $1 million and the property maintains that value for your first year of ownership so we can calculate your cap rate.

Net Operating Income / Current Market Value = The Capitalization Rate

$70,000 / $1,000,000 = 7%

This tells you that in that first year, your rate of return on the commercial building will be more than double that of the bond. Yes, there is more risk in the real estate investment, but that extra 4% of profit is your compensation for assuming that risk.

Ready To Start Investing In Des Moines Real Estate?

I’m glad that you’ve seen the light and realize that there is no time like the present to start building your portfolio of lucrative Des Moines investment properties.

However, not all investments, strategies, or properties are created equally.

That is why it is so important that you reach out to me so we can work together to build an investment strategy that makes the most sense for your unique circumstances.

P.S.

April really seemed like it flew by! Get excited for the flowers to bloom and the summer nights to return! Stay vigilant and look for unique ways to to invest!

As always,

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