How to Use Cap Rates (Yields) For Property Investment

What are Capitalisation Rates (also known as Cap Rates or Yields)?

Essentially they are a subjective method by which to; Value a property; Compare two, or more similar properties in similar locations; and Evaluate the financial feasibility of major renovation projects. So there is a lot of sense and value in getting to know how they work.

Investment Property and to a large degree, potential capital gains is explained by a series of quite simple mathematical calculations.

By mastering it you will be able to use these calculations to work out the approximate value of a property both now and later, once you have completed any renovations. That in turn will take much of the guesswork out of the game of property investment.

It is important to remember though, that rubbish data in will mean rubbish results out. So, assuming the method applied is consistent and the data used is factual, the numbers generated will be reliable.

To read my earlier post on how Valuers calculate the value of a property, Click Here.

Cap Rates are written as a percentage figure; anything from say 3% to 18%. The former tells you that the cash-flow (rent) is lower when compared to the value of the property. However, it will give higher capital gains when rents increase.

The latter is the opposite; it shows higher cash-flow (rent) compared to the value of the property; and a more modest increase in value should there be a rent increase. Each end of the spectrum has its own advantages and disadvantages.

 

Calculating Cap Rates

For this exercise, assume we are considering the purchase of a freehold block of 4 X 2 bedroom units for $1,000,000. Because the units are run down the current rent for the 4 units is low at $300 each per week or $1,200 per week for all 4 units [Ed: we’re talking Auckland here!].

Take the Annual Rental Income and divide it by the Purchase Price, then multiply that by 100 to give you a percentage figure.

A simple Cap Rate calculation would read as follows:

Gross Rent (Note 1) is $1,200 X 52 weeks (Note 2) = $62,400

Divide by the purchase price $1,000,000

Sub-total 0.624

To get a % multiply by 100

Cap Rate = 6.24%

 

 

Be aware that Valuers generally use a higher vacancy rate (say 4 weeks) and deduct specific costs for that property. Some Banks take 70 to 75% of the total income as the net income for their affordability calculations. It would pay you to find out from your Bank what calculations they use – just ask them.

 

In the next article we will see why Cap Rates fluctuate and how you can benefit from those fluctuations.

 

Note 1:

Gross Rent assumes costs are similar for comparable properties. However, deduct any unusual costs that might be peculiar to that property (e.g. ground rent for leasehold property, communal power that can’t be recovered). Whatever you do, make sure you use a consistent method.

Note 2: 
This assumes a full 52 week year with no consideration for vacancies. It implies that vacancy rates are constant between similar properties. However, a 50 week year is easier to calculate in your head (it thereby assumes a 2 week vacancy rate). If you would like to learn how to get your vacancy rates down to “0” download my FREE eBook, “Never Have Another Vacancy Again!” - just Click Here.  

 

 

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To gain access to my FREE Tenancy Forms,Click Here; or my Free eBook, “Never Have Another Vacancy Again!” Click Here.

 

By the way, if you or your friends, neighbours or family are ever thinking of selling your residential investment property, just click on Contact Meor call me on 021 980-770.

 

I’m always happy to help.

 

Regards,

 

John May

 

Disclaimer: Whilst every care is taken in the preparation of our content, all material is written as opinion pieces and general guidelines only. As such, no responsibility is accepted for the information contained herein. Appropriate legal and/or professional advice must be obtained by any reader or recipient at all times. Please Click Herefor our full disclaimer.

 

 

 

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