A capitalization rate, otherwise known as a CAP rate, is one of the best ways to determine the value while looking at rental homes for sale in Denver CO, but has also been one of the most misused formulas in real estate investing. The simplest way to find your CAP rate is to take your Net Operating Income (NOI) and divide it by the sales price.

But what exactly is your Net Operating Income? NOI is going to be your annual operating income minus your annual operating expenses. Let’s say the house you’re looking to buy is $100,000. It’s a three bedroom, two bath house in a desirable neighborhood. You could easily collect $1,500 a month in rent. Your expenses include taxes, insurance and maintenance fees—whether they be home owner’s association fees, landscaping expenses, or general wear and tear on appliances and household items. Let’s say these expenses add up to about $4,500 a year. So you take your twelve months of rent (that your tenant will hopefully pay on-time) at $1,500, for a total of $18,000 a year. Now subtract your expenses from your gross operating income ($18,000 – $4,500) and you arrive at your NOI.

From there, CAP rate is simple. You divide your NOI by the sales price ($13,500 / $100,000) and see that your capitalization rate is 13.5%, which is considered a very good return on investment, by the way.

While the CAP rate is a very good tool to indicate what kind of return you can expect, it typically leaves out very important variables, like if you’re financing the property, if your tenants skip rental payments or are destructive, or if you have unexpected maintenance issues to handle. For the most part, a CAP rate is just a quick way to show the potential profitability of an investment property, it in no way guarantees you that income.

When thinking about purchasing an investment property, there are quite a few factors to consider, over and above any CAP rate, or promises of an inflated rate of return. First, you should know exactly what you’re getting into; know that you will likely be paying more interest on an investment property home loan, and that you cannot deduct as many expenses as you would your own home. Next, you need to make sure you buy in a stable market, since buying an overvalued property can sink you even faster than living in one of your own. Lastly, you need to know that you can manage the property; find a good tenant that will pay on time, and who will not require a lengthy and expensive eviction.

About PorchLight Real Estate: PorchLight Real Estate Group has the most experienced and knowledgeable Denver real estate agents in Colorado. For more information about homes for sale in Denver CO or specific neighborhood homes please visit www.porchlightgroup.com.

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