As you navigate the real estate market you may have heard the term “Capitalization Rate.” What is capitalization rate, you ask? This cap rate is a way to determine how much you’ll make on an investment property. When we’re talking about a capitalization rate we’re usually in the realm of commercial properties.
This can include house hacking as well, though. Check out our article on house hacking as a way to generate residential income from your property HERE. Ask yourself, “How can I earn money off my property” or “How can I make money on my house.” And this article will help you learn a few new real estate terms. Real estate lingo can sometimes seem confusing but we’ll break it down for you. Let’s get on with learning the capitalization rate formula.
You’re basically going to divide the money you make from your property by its current market value. The amount you make is also called the net operating income. So, after expenses, it’s how much you actually have left over. In simple terms, if you rent you place for $1,000 each month and your expenses for management and repairs are $300, your net operating income is $700. The current market value is what your property is worth at any given time. Yes, this can fluctuate but in a six month period it’s typically fairly steady.
The capitalization rate formula will look like this:
The money you make on the property / Current market value
Of course this is usually a percentage rate and will essentially tell you how successful your investment is.
Earn Money off your Property
There are several ways to make money on your house. You can buy low and sell high. Some people rent the whole thing out or live there and just rent a room or two. Buying multiunit housing is also a great way to earn a lot of extra income. That’s right, not just making a little bit here and there but having an actual investment property. Multiunit housing is real estate lingo for a duplex/triplex/quadplex. This real estate term is for residential status so we’re not talking apartment buildings or hotels. But those can certainly make you money as well! The capitalization rate formula will tell you how much you can earn off your property. And you should be factoring it in when you’re buying an investment property.
High or low capitalization rate?
What is capitalization rate in terms of having that percentage be high or low? Long story short, a buyer/investor wants a high cap rate. A seller wants a low cap rate. Let’s think about it… Again with some easy math:
You buy a house for $1000 and you rent it for $2000. Your cap rate is 50%.
The current market value is ultimately what someone is willing to pay for it ($2000). The money you make on the property is $1000 (that’s $2000 minus the $1000 you bought it for). According to the capitalization rate formula, you’ll do $1000 divided by $2000 and your cap rate is 50%. You earned a lot of money on your investment as a buyer!
This really relates to property owners and what they can earn off their investment. For a rental property there’s something we call the 1% rule. Basically as an investor you want to make a minimum of 1% off your property. A rough estimate to do before you buy is to factor together a few things. Essentially, your purchase price and what you’ll make each month minus expenses are the main things. If you spend $200,000 on a property and rent it out for $2500 each month… Subsequently spending $500/mo on expenses for having the property, you’ve met your goal. Obviously the higher the percentage the better!
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This overview on capitalization rate is good to know when talking about investment properties. Whether you’re house hacking, renting a room, partial property, or otherwise, knowing the real estate lingo helps. Your next step is to find a great real estate agent that will help you find a great property to buy. Click below to get started on your journey to becoming a real estate mogul. You may be surprised at how much you can make!
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