What’s a common mistake you see when investors are considering a purchase?
Investors often rely too heavily on the first year capitalization (cap) rate when determining price. The cap rate—the projected rate of return based on the income a real estate investment property is expected to generate—is a good place to start, but it’s too simplistic to be the sole basis of an investor’s decision.
The cap rate is calculated by dividing the proposed purchase price by the current year’s income. If you’re looking at a property generating $50,000 in income this year, and the asking price is $500,000, it’s a 10 cap. In other words, the income is 10% of the sales price.
Sounds great, right? But there are many more factors to consider. For example, when is each lease expiring? Are the current tenants paying below market rate, or above it? What happens if you have to re-tenant? Will taxes increase based on the purchase price and thus reduce income? What is the projected income over the expected holding period? A dynamic model is required to distinguish a good investment from a bad one, and the cap rate should only be one factor.
If you don’t project the future correctly, you could find you’ve bought in the peak year of the investment, setting yourself up for disappointing returns and a drain on your overall portfolio. By conducting a discounted cash flow analysis, you’ll gain an understanding of what is likely to happen over the expected holding period, and ultimately determine the true worth today. This kind of analysis provides far more sophisticated and dynamic data, and it forms the basis of a sound investment decision.
– Russell Lamb, Principal