Many of you may be asking yourselves, “How can I use cap rates to predict real estate investing profits?”
Let’s start with defining the capitalization rate so we can understand what a good cap rate really is. (Free Cap Rates Profit Report, click here.)
The capitalization rate is an investment measure that’s defined as the ratio relationship (reflected as a percentage) between the first year’s net operating income and the purchase price of your investment.
In English, this means that if you pay $1,000,000 cash for a property and you receive $100,000 in cash flow over the next 12 months, your capitalization rate would be 10%. Or, if you were seeking to purchase property at a 10% cap rate and were considering a $1,000,000 investment, you would you receive $100,000 back in the first 12 months.
Here it’s illustrated as a mathematical formula.
The Capitalization Rate Formula
Income ÷ Value = Rate | $100,000 ÷ $1,000,000 = 10%
Rate x Value = Income | 10% x $1,000,000 = $100,000
Income ÷ Rate = Value | $100,000 ÷ 10% = $1,000,000
What if that same property that’s worth $1,000,000 throwing off $100,000 starts producing more income per year?
Let’s say you purchased the property and made some improvements to the building, hired better management, and eliminated wasteful expenses. You’ve improved the bottom line and at the end of the year, you’ve added $25,000 to the annual income, bringing your total net operating income to $125,000 per year. Nicely done.
It doesn’t sound like much, but here’s where it gets exciting. Apply your profits formula to this property and see what’s it’s worth.
Start with calculating your new value based on the improved bottom line net operating income you’ve created and then subtract the value that you paid for the investment. The difference between those two numbers reveals the profit on the investment.
Here’s an illustration of how it works.
The Cap Rate Profits Formula (Click here for a Free Cap Rates Report)
Exit Value: $125,000 (Income) ÷ 10% (Rate) = $1,250,000 (Value)
– Purchase Value: $100,000 (Income) ÷ 10% (Rate ) = $1,000,000 (Value)
Your Profit = $250,000
Small changes to the operations of a property mean big profits when you sell the investment. That’s why investors love commercial real estate. They seek out good cap rates. Then they improve the net operating income by driving more income to the bottom line. When they’re done and ready to move to the next investment, they sell the property for big profits fast.
By the way, where should we send your free 10 part email mini course? It’s 100% commercial real estate investing focused and you can get it here.