Renovating a multifamily house can be a fantastic way to build your family’s fortune! Many people dream about “buying and holding” real estate for the income it provides. But before you buy a property to hold for income, you must calculate the property’s “cap rate.“ Cap is short for capitalization. This cap rate is the percentage return the property brings in after the rental income is reduced by the annual expenses, incurred in “running” the property.
The investor decides what “cap rate” he or she is looking for. The cap rate is inversely proportional to the popularity of the area. In very desirable areas, the rate might only be 4% (because costs of real estate are higher) and in lower demand areas, more transitional areas, the rate should be higher, because the real estate is cheaper. Generally, a cap-rate between 4% and 10% is a good one. But you have to decide for yourself. What rate are YOU looking for?
Once you have that cap rate in mind, you apply the following calculation to the numbers involved. You essentially take the annual rent, minus costs. The costs include mortgage payments, if any; real estate taxes; insurance, an allowance for vacancy periods (say 5% of the income) and “maintenance” (things like heating and electric for common areas, etc.
So, hypothetically, the real estate property costs $200,000 & there is no mortgage.
TAKE TOTAL ANNUAL INCOME:
If the rental income is $3,000 per month, that = $36,000 per year.
If the mortgage payment is $1,000 per month, that = $12,000 per year.
Taxes: = $5000 per year.
Other costs: (insurance, utilities, maintenance, etc.) = $7,000 per year .
TOTAL COSTS: $24,000;
NET INCOME = $12,000
$12,000 (net income) divided by $200,000 (the price of the property) = 6%.
That means the cap rate is 6%. Excellent!
Let’s take a look at a recent acquisition and how the cap rate works out…
This two-family home offers 2 bedrooms in one unit and 3 bedrooms in the other. We calculate the rental income to be $2,500 per month. That equals $30,000 per year; Taxes are $8,000; insurance will be $3,600 and we’ll subtract $1,500 for a 5% vacancy rate, and we’ll put aside $1,200 per year for a “reserve fund.” Income is $30,000 minus $14,300 = $15,700. Divide $15,700 by the cost basis in the house of $200,000 and the cap rate for this house is 7.8%! Excellent!
7.8% is an excellent cap rate! Should we keep it for income…or sell it…..?
What’s your opinion?
Stay tuned for our next blog about Investing in Multifamily Housing (Step 2)!