Understanding how to calculate the return on a real estate investment can be instrumental to ensure that you make the best use of your resources. To understand the basics use the following guidelines:
The standard of measurement is to use annual net operating income (NOI) on a care-free basis when comparing real estate against other investments. That is, any costs involved in the real estate investment should be accounted for so that the real estate investment is hands-off, or “carefree”. The costs of maintenance, management or accounting, etc to manage your real estate must be deducted to arrive at the NOI. Even if you are quite capable and enjoy performing the maintenance or management of your investment real estate, you must allocate an equivalent cost for someone to perform these tasks to arrive at a net operating income. Other costs that you will want to ensure are captured will be taxes, insurance, utilities, vacancy allowance, advertising, licensing and supplies. Then when you have arrived at your true annual NOI you can calculate the capitalization rate or “cap rate”. To do this, take the annual NOI and divide this number by the current value of the property.
For example, if you purchased a rental property for $400,000 that brought:
$2200 gross rents per month or $26,400 in gross annual rent
Your expenses cost you:
Vacancy Allowance $1,200
Less Total Expenses: $6,600 annually
($26,400 – $6,600) Net Operating Income = $19,700
To calculate the cap rate divide the income by the value of the property:
$19,700/$400,000 *100 = 4.9%
So the cash flow from this property is returning you 4.9% on a care-free basis. This is now a good basis to measure the return of your real estate portfolio against GIC’s, stocks and other care-free investments.
What the cap rate does not anticipate or calculate is capital gains in the increase of the value of your real estate holdings and this would be in addition to the cap rate calculation. Real estate has historically appreciated in value over the long term so it is a fairly safe assumption that you will realize some additional appreciation from your investment. However, even with no capital appreciation, you may be satisfied with a reasonable cap rate.