Cap Rates and Return on Investments
March 30, 2017
Guest blogger on Cap Rates and Return on Investments:
So I was sitting down doing some math last night trying to figure out what I am going to do with some money I am getting from the sale of our old office building. My plan is to do a 1031 exchange and buy an apartment building somewhere in California. So I started to look at the numbers and the key when you look at commercial building is the Capitalization Rate and of course the return on investment. I look at the same thing when I look at residential properties, but this is like buying 10 residential properties so I need to be careful. What I found was pretty amazing and I hope this doesn’t bore you! If you buy a $100,000.00 Commercial property at a 4.0% interest rate with a 5% Capitalization rate then your return on your investment is 8% assuming no appreciation. If you buy the same building with a 4.5% interest rate and a 4.5% Capitalization rate then you would have a 4.56% rate of return on your initial investment.
So looking at that I can still make a case for the 4.5% cap rate with the 4.5% interest rate because of the lack of inventory and the crazy rents that are going on at this time, but I like the first one much better. So to put this into terms of a single family residence which is where most investors start. Using my favorite 3+2 1128 square foot Sunrise Home that will rent for $2500-$2600 per month. This property will cost about $460,000.00 and your rate on a rental today is 4.625% with 25% down and you would have a 4.933% Cap rate and a 6.5% Return on your investment with $2500.00 in rents. If you rent for $2600 then your Cap rate goes to 5.19% and your return on investment jumps to 6.72%. As rents get more expensive your Cap Rate and ROI will increase and if property values increase by just 3% per year then your actual ROI will be closer to 18%! Yes a 3% increase in price is 12% gain on your initial investment and that is why Real Estate is so AWESOME!!!
If you hate numbers then skip this section!
Return on Investment (ROI) – Take the annual profits and divide by the amount of your investment. $100K Price 25% down = 25K // Profits are $1500.00 annually then you have a 6% Return on investment! Divide $1500 by $25,000 and you get .06 or 6%!
Capitalization rate (Cap Rate) – is the rate of return assuming a property is purchased for cash. So if you have a property where you pay $100,000.00 and after all expenses you receive $5000.00 per year then you have a Cap Rate of 5%. Cap rates are higher when interest rates go higher because there is not usu
ally enough cash out there for the lower capitalization rates.
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