Cap Rates etc.
In real estate investing, many terms and abbreviations are used. Experienced investors generally know how to calculate things like capitalization rate (Cap Rate) and cash-on-cash return, but below is a review. We have also listed the 5 profit centers of turnkey investing.
CAPITALIZATION RATE
The Cap Rate is the net income (expressed as a percentage) which a property is expected to generate were you to purchase for cash. It is calculated as follows:
Starting with the monthly rent, subtract the monthly proportionate amounts for all direct expenses. These are:
- Property Management
- Property Insurance
- Property Taxes
We also recommend calculating and setting aside contingency amounts for:
- Maintenance (we use 5% of rent)
- Vacancy (we use 7% of rent)
After subtracting these amounts from the monthly rent, you are left with the monthly Net Operating Income (NOI). Multiply this figure by 12 to arrive at the annual NOI. To calculate the Cap Rate, divide the annual NOI by the gross purchase price.
CASH-ON-CASH RETURN
Cash-on-cash return is the rate of return (expressed as a percentage) that calculates the income earned on the CASH INVESTED in a property. It is calculated as follows:
Starting with the monthly rent, subtract the monthly proportionate amounts for all direct expenses. These are:
- Property Management
- Property Insurance
- Property Taxes
We also recommend calculating and setting aside contingency amounts for:
- Maintenance (we use 5% of rent)
- Vacancy (we use 7% of rent)
In addition to the above, you also deduct your monthly mortgage payment (we estimate in this example an 80% mortgage for 30 years at 4% interest)
After subtracting these amounts from the monthly rent, you are left with the monthly Net Operating Income (NOI). Multiply this figure by 12 to arrive at the annual NOI.
To calculate the Cash-On-Cash return, divide the annual NOI by the NET CASH OUT OF POCKET used to purchase the property. This is made up of three components:
- Down Payment (often 20% for single family properties)
- Closing Costs (roughly 3% of total purchase price)
- Finance Fees and costs (roughly 3% of the loan amount)
The resulting figure will be your Cash-On-Cash Return.
THE 5 PROFIT CENTERS OF TURNKEY INVESTMENT
POSITIVE CASH-FLOW: By buying in an investor-advantaged market (all of our properties are in investor-advantaged markets) you will enjoy net positive cash flow even after subtracting all of your direct expenses from the monthly rent.
EQUITY GROWTH: Your mortgage payments are covered by your tenant’s monthly rent, thus increasing your equity ownership of the property each month.
APPRECIATION: Appreciation is not the reason why investors buy turnkey property (only speculators do that). However, so long as you buy in a growth market, you have a reasonable expectation of your property appreciating.
TAX BENEFITS: Everyone’s tax situation is different but owning investment real estate provides multiple tax benefits for all such as write-offs for expenses incurred and even the opportunity to gain “real estate professional” tax status.
INFLATION HEDGE: Especially relevant in the current environment with inflation hitting new highs for the last 40 years in the US. When you buy with leverage, you’re buying using valuable “today” dollars and paying back over time with inflation-eroded less valuable “tomorrow” dollars while still enjoying full credit for those lesser-value dollars.