People think you can get wealthy off real estate just by buying an investment property. You can also lose all your money, if you do not know what you are doing. Buying real estate is great, but making smart real estate decisions is way better.

There are a lot of definitions of a good investment property, and different buyers look for different things. The premise of a “flip” property is pretty easy to understand. Buy low, fix, sell high. Simple.

But what about long term investment properties? 

There are 2 numbers you should look at when determining if the investment property you are looking at is good choice. You need to look at the cap rates and cash on cash return.

What is a Cap Rate?

When you buy investment property, your first step should be to determine your desired returns.  Many real estate investors use the cap rate formula to initially check if a property meets their minimum criteria.  They will set a desired cap rate up front and only look into properties that meet this initial criteria.

The capitalization rate, or the cap rate is the rate of return on a real estate investment property based on the income that the property is expected to generate. It is used to estimate the investor’s potential return on his or her investment. The formula to figure out your cap rate is simple.

(Net Annual Income / Purchase Price) x 100 = Cap Rate

Your net income is the money left over after all bills and expenses are paid. Gross is the total amount of rent you receive.

For example, let’s say you buy an investment property for $100k, and you’re able to pocket $500/month after all bills & expenses are paid.  This is your net monthly income. $500/month net income x 12 months in a year = $6000 Net Annual Income

($6000/ $100,000)  x 100 = 6% Cap Rate

 Now some will argue that a “6 Cap” isn’t worth the investment and wouldn’t touch it with a ten-foot pole. Other investors may look at Cash on Cash Return and think differently.

The first thing I would recommend is finding out what cap rates most other investors shoot for.  When a property has a lower sales price, the caps are typically higher.  These properties may also have more management duties required since the properties tend to be older and need more maintenance and work.  

If you were to look at a true armchair investment property you may look for a lower cap rate. These properties basically rent themselves when put up for lease because they are newer and in a desirable area and should require basic upkeep.  

When you begin narrowing down your area and strategy, you want to take in the cap rates of different areas and see if you can find some trends.

Cash on Cash Return

Your cash-on-cash return is the ratio of annual before-tax cash flow to the total amount of cash invested. In other words, it’s the percentage of return on your out of pocket cash invested into an investment property.

(Net Annual Income / Cash Invested) = Cash on Cash Return

Let’s use that same $100k property in our Cash On Cash calculation. Assume we got a loan for 80% of the purchase price or $80,000 on a $100k property. In this example the buyer would put down 20% or $20,000.

$6000/ $20,000 = 30%

If they were to net $6,000 a year on that investment property, they would see an annual return of 30% based on the money invested.  That’s better than any mutual fund your bank has ever offered you.  

Something to take note of is that any financing or mortgage costs are not considered in cap rate calculation while the cash on cash return metric is entirely dependent on financing, and is always taken into consideration. 

The interest rates won’t affect it much, but the down payment amounts will change the number the most. So if you only can use one of the two, use the Cash On Cash return, unless you pay cash for the property in which case they will be the same.

When considering buying an investment property, It’s up to you to determine which metric is more important.

A lot of investors believe that cap rates only matter when you’re buying or selling a property. It’s one of the quicker and more popular metrics showing a property’s value based on the income it generates.

I hope this article was helpful in determining how to figure out the value of a potential income property.  If you have any questions let me know and I would be happy to reach out and help you make your investing dreams come true.