Investing in rental properties can be an incredibly lucrative opportunity. It is necessary to understand the concept of cap rate or the capitalization rate of a given property in order to determine the profitability of the property. The capitalization rate, or cap rate, is the annual rate of return investors expect or require from a rental property. The cap rate of a new or renovated property can be estimated by looking at the cap rates of nearby comparable properties. Once you determine a cap rate, you can use it to calculate the market value of the real estate property.

Cap rate is important for real estate investors, as it provides them an accurate estimation of the profit margin that one may be able to obtain from the property. It provides the investors with an opportunity to realize the returns that they will get on the investment made by them, and to compare the investments before they actually invest in the properties.

 

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What is the typical tenure that I can compare a similar property to my property?

The usual method that is employed while selling real estate property is to compare the sale of recently sold similar properties. A seller can use sale amount of similar properties in order to justify the asking price to the buyer.

It is important that the sale of the similar properties is neither an active listing nor is it pending in sales. It should be a property that has already been sold and is not for sale anymore.

A property is said to be similar to another property if –

  • The property has been sold within a time period of 3 months
  • The properties are similar to each other in terms of square footage area
  • The properties are present in the same locality
  • The properties are of similar construction

The sales comparison approach should be reviewed from time to time because of the constant change that occurs in the real estate sector. There should be proper due diligence in order to check the prices of recently listed properties for sale. Keeping a shorter time frame of sale between comparable properties, makes it easier to verify the trends in the real estate market.

I bought property spending more than the actual value of the property. Will it raise any legal issues?

Before buying property, it is important that the buyer conducts due diligence and finds out the actual value of the property. There may be times when the selling price of the property is higher than the actual value of the property, or the property may be sold at a value lower than the stamp duty of the property.

Buying or selling properties at a value lower than the stamp duty value of the property to save on the costs, causes loss of revenue to the Government. It is observed that the Government will not certify the sale deed for a transaction between parties that is below the actual stamp value of the property. It also leads to a loss in the collection of stamp duty value. In case it is seen that property has been received without any consideration or the fact the consideration is inadequate, the stamp value of the property received is stated to be the income tax return. This is done to avoid the evasion of payment of stamp duty by buyers.

How do you calculate the value of the property using cap rate?

The capitalization rate or the cap rate is the anticipated returns that investors expect from a rental property if the property was purchased with cash. The cap rate of a new or renovated property can be estimated by looking at the cap rate of similar properties. Once the cap rate has been established, it can be used to calculate the market value of the real estate property.

The cap rate can be used to find out the value of the real estate property. A property value equal to the net operating income is obtained by dividing by the cap rate. The net operating income is the total income which is generated from the property, subtracting the operational costs incurred. The operational costs include maintenance, repairs, payment of property tax, etc.

A property with a higher cap rate would result in a lower value of property. The existence of variations in the variation of the cap rate would have a significant effect on the value of the property. It is observed that the use of cap rates of similar property is risky in nature, as all the properties are not identical in nature, and thus, adjustments would have to be made.

Conclusion

People who invest in real estate via income-producing properties should have a method to determine the value of any property they’re considering buying. Cap rates are widely used in commercial and multi-family property valuation and profitability studies. It is an important device that is used to calculate the investment to be made in commercial real estate. The cap rate should be identified correctly before investing. They can be used to determine a good sales price, or the value of a listed property versus the asking price.

The cap rate that is obtained gives the buyer/real estate investor an estimate about the annual return on the investment made in the property. There are many factors that may affect the cap rate of the property.