With many distressed properties on the market, many investors are looking at purchasing aggressively priced multi-units to convert into investments properties. In many areas, rental rates have either stabilized or increased in value due to demand. Additionally, some properties are in need of repairs to make them habitable. How can you be sure whether those tentative investments are going to be profitable, break-even or in the red?
Many look at the capitalization rate which is the ratio between income and its capital cost. The most basic method of calculating the capitalization rate (commonly referred to as cap rate) is by taking the annual net income produced on the property and dividing it by cost (price paid or possible market value).
Throughout the city, you will see cap rates vary from 2% all the way to 10% or even over. Properties with less risk produce a lower cap rate, whereas properties with higher risk usually have higher cap rates. In many cases there is no current rental income due to vacancies, or rental income is significantly below market value. In these instances, an estimated rental value will be used to calculate the adjusted capitalization rate.
The capitalization rate only recognizes the current income that a real estate investment currently produces and does not take into account appreciation / depreciation. Changes in rental income would also create a different capitalization rate.
Additionally, sometimes an investment is financed, or there is a significant investment (major construction for example) at some point. Calculating the return on investment (ROI) is helpful to understand the break-even point and when the investment is fully paid back. Return on investment measures cash flow relative to the amount invested.
Because of the many distressed properties currently on the market, many are seeing exceptionally high capitalization rate, sometimes in the range of 90%. When looking at distressed properties, the value used should be adjusted to reflect not only acquisition cost, but as well as construction costs, liens and possible taxes. With many purchases currently being paid for fully in cash, there may be no real difference between the cap rate and ROI.
Although the capitalization rate is helpful for analyzing or even comparing properties, is should not be the only measure used when evaluating investment properties. Supply and demand will affect rental rates. Location will impact overall property value.