Things You'll Need:
- Yearly Income Potential
- Purchase price or market price of investment property
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Step 1
The first step is to identify the market value of a property. This value can also be the purchase price one expects to pay for the property. A Realtor, home appraiser or tax consultant can help determine a properties value if the potential home is not already listed for sale.
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Step 2
The next piece of information needed is the Annual Net Operating Income (NOI). This is calculated by taking the expected rental income from the property over a 12 month period, and subtracting off any costs associated with keeping the home rented for that same 12 month period. Typical costs include property taxes, management fees, expected repairs and maintenance costs, and insurance. Do not include mortgage payments as part of the cost, since Capitalization Rate is used to compare properties to each other as if they were purchased with cash. This provides a more accurate comparison.
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Step 3
To calculate Capitalization Rate, or Cap Rate, you divide the Annual Net Operating Income by the purchase price or market price of the property. Cap Rate = Annual NOI / Purchase Price. For example, if the Annual NOI of a particular property is $12,500 per year (Rent income minus cost to maintain the property), and the purchase price of the property is $150,000, the Cap Rate would be 8.3%. Generally Cap Rates for investment properties are between 5% - 8.5%. Most investors prefer close to the 8% mark, however ranges vary depending on location. The Cap Rate for each property can be compared to understand what property is the most valuable to an investor for the current property price.
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Step 4
Cash on cash return can be calculated using the Annual NOI, but this time debt payments (such as mortgage payments) should be deducted from the Annual income to calculate the NOI. Cash on cash return can then be calculated by dividing the Annual NOI by the sum of any down payments put on the home during purchase as well as repair costs incurred in order to rent the home. For example, if you put $25,000 down payment to purchase an investment home, and pay $5,000 in repairs to ready the home for rental, the NOI is divided by $30,000. In this example, if Annual NOI on the property is $3,000, then the Cash on cash return would be $3,000 divided by $30,000, or 10%. This means the investment property is earning the investor 10% on money invested.
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Step 5
Using both Capitalization Rate and Cash on Cash Return to compare investment properties is a fairly simple and objective way to determine which property is a better value.
