Understanding CAP Rate, Return on Investment (ROI), And Equity Return Rate

When you are looking to purchase income property for investment purposes you are bombarded with various statistics designed to show you the strength of the investment you are considering. These numbers can be very helpful IF you understand exactly what they mean and what constitutes a “good” rate of return. To help you accurately evaluate potential investment properties in Las Vegas and elsewhere, it is important to start with a working knowledge of the three main formulas used to evaluate potential real estate investments.

First is the Capitalization Rate or CAP Rate. You will probably see this formula used more than any other when describing the investment potential for a particular piece of real estate. The CAP rate is determined by dividing the NET Annual Operating Income by the Acquisition Cost of the property. NET Annual Operating Income is defined as the total of rents collected in a year minus all expenses associated with owning the property. These expenses may include: property taxes, HOA dues, any utilities paid by the owner, vacancy allowance, repairs/maintenance allowance, property management, and property insurance. Acquisition Cost is defined as the total cost necessary to purchase the property...so purchase price plus all closing costs, title and escrow fees, etc.

Using the above formula, if you acquired a property for $200,000 and the NET Annual Operating Income of the Property was $20,100, then you would have a property with a CAP Rate of 10%. In my next article, I will discuss how to determine a good rate of return.

The second type of return discussed with regards to income properties in Las Vegas and elsewhere is ROI or Return on Investment. If you paid cash for your investment property, then your ROI and your CAP rate will be identical. If, however, you purchased a property using financing, then your ROI will be the NET Annual Operating Income of the property divided by your initial equity investment (cash in the form of down payment, any out of pocket closing costs, etc.) Using this formula, we can see that if we purchased the same property as above and put 25% down ($50,000) then our ROI would be $20,100 divided by $50,000 = 40% ROI. As you can see, financed investments can allow you to leverage yourself into a much higher rate of return for your money than all cash purchases. We will touch more on that topic in my next article.

Another evaluation tool that is extremely useful in determining how much bang you are really getting for your buck is the Equity Return Rate. This is a slightly more complicated formula. The first step is to add your Cash Flow After Taxes with your Amount Paid Towards Principle and Change in Value to the Property. Cash Flow After Taxes, or CFAT, is simply your NET Annual Operating Income minus whatever taxes you paid on that income or plus whatever tax benefit you received because of your deductions for the income property. (During the first several years of property ownership, you will likely show tax savings and add them to your NET Operating Income in order to obtain your CFAT. In subsequent years, as your deductions mature, you will start subtracting taxes paid from your NET Operating Income to obtain your CFAT.) Amount Paid Towards Principle represents the total amount of your mortgage payments over the year that were applied to your principle balance. (On the first year of your property ownership this number will most likely be quite low and will grow each year.) Change in Value represents the amount that your property has appreciated or depreciated in the previous year. Once you obtain this sum, you divide it by your initial equity investment in order to obtain your Equity Return Rate. Using our previous example again: If your CFAT is $20,100 plus your Amount Paid Towards Principle of $1,627 and an appreciation of $6,000 (totaling $27,727) divided by your initial equity investment of $50,000 gives you an Equity Return Rate of 55% for your first year of ownership.

I specialize in offering quality, turn-key investment properties in Las Vegas to my investor clients worldwide. I ensure that all of my properties have a great ROI and Equity Return Rate. Tune in to my next article to learn how to determine what makes a “good” rate of return!

Glenn Plantone
Wynn Realty
(702) 656-3264
gsplantone@gmail.com

www.glennplantone.com

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