An investment property is a land, a building, or a section of a building held by the owner or a lessee to gain profits from the rentals, capital gains through appreciation of the property, or both.
The primary intention for purchasing or leasing a real estate property is to earn a return on investment from the property. This can be through rentals or future resale of the property. Such a property can be held by an individual, group, or company.
Before delving into real estate investment, you should have a thorough understanding of the various terms, such as a reasonable cap rate and the 2% rule. Also, consider the risk ratings of the different investment properties available.
What Is A Good Cap Rate?
Generally speaking, a reasonable cap rate depends on the property you are looking to invest in. For instance, when investing in commercial properties, a 4% cap rate in high-demand and less risky areas or a 10% in a lower demand area is considered reasonable.
Usually, a good cap rate should fall between 4% and 12% depending on the demand, type of property, and the available property in the specific area. Considering the cap rate is vital in ensuring you do not take a loan for a product that cannot pay for itself.
When purchasing an investment property, it is essential to ensure that you are entering in profitable business. If you are not sure of the volatility and risk of investment, always conduct in-depth background checks and due diligence on the property and the area you are investing in.
Factors that Determine A Good Cap Rate
Determining a reasonable cap rate depends on the property and the market in which you are investing in. However, factors such as available capital, risk profile, lease strength, and location can guide you.
While the available capital does not impact the cap rate, it is essential to follow the general rule that never uses mortgages or debts that are more expensive than the stabilized cap rate of the property.
The risk profile of an investment property can also be used to determine whether the cap rate is suitable for investment. In real estate investment, a cap rate of less than 5% indicates a low-risk profile, while a cap rate above 7% indicates high risk.
The location of the property is an essential indicator of whether a cap rate is reasonable. The location of a property determines the demand for the property. The higher the demand for property, the higher the value for the property, and the lower the cap rates.
The lease strength of a property is determined by conditions of the lease provided by the property owner. Also, the financial ability and economic prowess of tenants within the area where the property is located determines the lease strength. A high lease strength indicates a low-risk profile for the investment property.
Calculating the Cap Rate
There are numerous ways of calculating the cap rate, but the easiest way is by dividing the net operating income by the current market value of the investment property, as shown in the following formula.
In this case, the net operating income for the property is the annual income generated from the property. This is net income after deductions that may include property maintenance, property insurance, management fees, and other miscellaneous bills.
However, since it can be a daunting task to account for every expense, it is always a good idea to set aside a 1% value of the property to maintain the property. Nonetheless, always remember that the cap rate is not the only indicator of a good or bad investment.
Other indicators that you can apply when considering property investment include the 1% and 2% rules, the diversity of the tenants, population growth in the given area of investment, and the underlying economic fundamentals of the region you are investing in.
The 2% Rule in Real Estate Investment
When evaluating an investment property, 1% and 2% rules can help assess if you are making the right move. These rules are essential in determining the potential cash flow from a specific property.
Based on 1% and 2% rules, you can tell whether the investment property has a positive cashflow potential; hence, a good investment. These rules determine whether the monthly income from the investment property is equal or higher than the monthly repayment amount.
According to the 1% rule, if the monthly return from an investment equals or exceeds the monthly loan repayment, it is a good investment. In contrast, based on the 2% rule, if the monthly income equals or exceeds 2% of the purchase price of the investment property, then the investment is worth it.
The 1% rule suggests that if a property costs $100,000, the monthly return on investment should equal or exceed $1,000. Consequently, the 2% rule indicates that property worth $100,000 should return at least $2,000 per month.
Interest Rates and Cap Rates in Real Estate Financing
When investing in Real Estate through asset finance plans, it is essential to understand how the cap rates can affect the interest rates. As a real estate investor, understanding the relationship between interest rates and Cap rates will help you make an informed decision.
If the government adjusts the interest rate, this can cause the cap rate to fluctuate even when the property has not been changed. As such, the increase in interest rates causes a fall in property values.
A rise in interest rates causes a surge in debt and a decrease in the net cash flow. Consequently, even if you do not have direct control over the interest rates, you should know how this affects your investment.
One fundamental rule concerning cap rates and debt indicates that; cap rate only refers to unlevered numbers. In this regard, you cannot use the debt in the calculation of the cap rate. This will help guide you when making a property investment.