Most seasoned investors are familiar with how to determine value of an investment by its CAP RATE. But novices - and even a few "pros", are confused by this method. So, here it is in a thimble:
CAP RATE stands for Capitalization Rate - the rate at which an investment produces a return on investment. The higher the cap rate, the faster you get your investment back, and the richer you get. Simple, eh?
But just how do you figure CAP rate?
tep #1 - determine the annual NET rental income from the property (gross rents minus expenses, such as tax, insurance, maintenance etc.)
Step #2 - divide the net rent by the fair market value (FMV)
Let's say you find a complex with FMV of $250,000. You estimate net rents would come to $2,000/month, or $24,000/year. By dividing 24,000 by 250,000, you have a CAP RATE of 9.6%. If that is not good enough for you, then you must either get a lower price, increase rents, or walk away.
For most investors, a CAP rate of 10% is absolutely minimum, and many investors won't consider anything less than 12-15%.
More important, you can use this method to determine the maximum you should pay for a property, based on the CAP rate you need to get. For example, if you need to get a 10% CAP rate, and the net rent is $24,000 per year, you would divide 24,000 by 10% (24,000 x .10), which comes to $240,000 - the max you should pay to get a cap rate of 10%.
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