As an investor in real estate, there will be many times when multiple opportunities are available at the same time. Unless you have an unlimited amount of funding, you will need to make a choice between different properties. But, how do you decide? Although there are many things to take into consideration when making a decision, one measurement that can be useful is the capitalization rate. In a real estate investing context, the capitalization rate pretty much means: “How much rent can I collect in a year for each dollar that is spent on acquiring the property?” It can also be thought of as a measure of how quick you will make back your original investment.
Calculating the cap rate is very easy. Add up all the rents you plan to collect for the year and then divide by the purchase price. For example, if you will collect $10,000 in yearly rent and pay $100,000 for the house, then the cap rate is 10%. As you can see, larger cap rates are better. With a 10% cap rate, you are making your money back in 10 years. With 20%, you are making it back in 5 years. So with everything else being equal, the property with the largest cap rate is usually the best investment. But, everything else must be exactly equal such as same neighborhood, same maintenance costs, etc.
This is not a perfect measurement of real estate investment comparison. It is only one tool to use. There are many other things that can shape your opinions of a property. Sometimes you may want to accept a lower cap rate if the property is in a nicer neighborhood. I would stay away from a property with a cap rate of 80% (which is great) if the property was in a dangerous neighborhood. Generally the cap rates on single family homes are lower than those of multi units. Single family homes are generally easier to sell and easier to move if the need ever arises. Don’t use cap rate alone to access your investments, but do use it along with other assessment criteria to make wise decisions.