Analyzing Short Sale Rental Properties

In their rush to get in on the boom in real estate—the boom that preceded the bust–many new real estate investors made (in retrospect) a rather fatal error. Many small investors just didn’t look hard at the profitability and financial leverage numbers with any real degree of sophistication.

That’s too bad, really, because three simple formulas would have given them huge insights into the investments they made and may have even given them an early warning when the real estate investment market become dangerous. Income Capitalization Rate Formulas The first tool that far too many investors ignored at their great peril was the income capitalization rate formula.

A property’s income capitalization rate is a simple percentage calculated by taking the net income generated by a property and then dividing this value by the property value. Suppose some investor is considering a $100,000 rental property that generates (say) $10,000 of rent and which requires $5,000 of a year of operating expenses for taxes, insurance and maintenance. In this example, the net income for the property equals $5,000 because $10,000 of rent minus $5,000 of expenses equals $5,000 Further, the capitalization rate equals five percent because $5,000 divided by $100,000 equals.05. By the way, a capitalization rate, also known as a cap rate, is interesting in and of itself.

The cap rate, for example, lets you know how much income and cash flow a real estate investment generates. And that information is useful for verifying that you’ll be able to cover the mortgage payments. Capitalization rates, however, also become useful if you want to make more sophisticated calculations of the property’s financial profitability as is possible with the next two formulas I discuss. Property Rate of Return Formulas Once you have a property’s cap rate, you can estimate the property’s overall rate of return. Sometimes this is also called a project rate of return. To calculate a particular property’s rate of return, you add the capitalization rate to the inflation rate you expect for the property’s value. For example, if the cap rate equals five percent and the inflation rate equals two percent, the property’s overall rate of return equals seven percent. Note: If you buy a property without a mortgage, the property rate of return is the annual return you’ll earn on the investment. Cash buyers, in other words, earn the property rate of return on their investment.

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