It’s all about that CAP rate, or is it?
As a real estate investor if you were to only rely upon just one method of evaluating the investment potential it may not only be detrimental to your profits on each deal, but eventually it may end up costing you all of your money!
On this post we’re going to evaluate several real estate formula’s that could ultimately put us ahead of our would be competition.
So what is I.R.V. anyhow?
IRV is a formula that allows us to evaluate in different formats the potential investment we are looking at in the moment. We can understand the CAP Rate, (most of you’ve heard this one bantered about in the Social Groups), but we can also evaluate the yield we seek, or the CASH-ON-CASH Return we might make given a certain estimated profit. There are several, which we will cover below.
First let’s look at what IRV represents.
Let’s look at some ways to use the formula!
CAP RATE: You may have heard of a CAP Rate, but you might not be sure how it works, exactly! We’ve all seen the posts by investors stating the property has a “10% CAP”, or a “12% CAP”.
So which is better, a 10% or 12% CAP Rate?
The short answer to that question is, it depends. The actual use of the CAP Rate, or “Capitalization Rate“, is to Compare Investments. You would then need to know how the market around the subject property boasting the CAP is actually performing.
There are other considerations as to whether a specific CAP Rate is good for you. Are you Buyer, or are you the Seller? As a Buyer you may want a higher CAP, as a Seller a lower CAP is almost always better. It comes down tot he fact that the CAP Rate is the cost of the asset
See, the CAP Rate denotes a Higher Valuation when it is lower, meaning, a 5% CAP Rate is a Higher Valued property than a 10% CAP Rate given a defined NOI (“Net Operating Income“, it is also called EBIT or Earnings Before Interest and Taxes). Confusing huh? Look below, this is the formula, (Remember I.R.V.).
Here watch – (using the above formula – again Remember I.R.V.):
We have a building we are evaluating that we’re told has a NOI of $10,000 (annually). The owner is asking $100,000. Using the formula we can ascertain that the CAP Rate on this property is 10%. In other words after we have paid out expenses (EBIT) we will have $10,000 left to pay our Real Property Tax Bill and Interest on the loan (if one was taken out, it can also be Principal and Interest, depending on the loan). So in order to pay our “debt service” we must know if the NOI will be enough.
Remember the question was, which rate was better, 10% or 12%? So how do we calculate the given NOI amount to come up with a CAP Rate of 12%? We already know how we got the 10%. Simple, use the same formula, (Remember I.R.V).
What we really want to know is how much will this property cost for that 12% CAP Rate. So start with; Income = $10,000, we want a 12% CAP, so then we enter .12, we then solve for the answer. Take out your calculator – now enter – 10000 then the division sign – now enter .12 (be sure to enter the decimal point) – now press the equal or solve button and you will get the answer of $83,333.33. So which would be better for you? See how it depends on if you are the buyer or seller?
Now you next job is to compare other buildings in the area to see what their CAP Rates are reflecting. This will help you to determine if the seller is asking too much for their property or not.
This post is starting to run longer than originally wanted so we will continue on another post(s) showing other ways to use the I.R.V. Formula.