How to Turn an 8% Cap Rate into a 14% Return on Equity
Recent policy changes on rent increases combined with the pandemic essentially halted all economic activity. This is why investors now focus on the property’s cash flow to evaluate a good real estate deal. Investors used to look at upside in rents. However, since the rent law changes eliminated upsides, we are faced with the challenge of maximizing rents and stable rent collections. Properties with Section 8 tenants have been more attractive because of these challenges. Rents are at par with market and because tenants are mostly subsidized by government, rent collection has been consistent even during the pandemic.
The first thing to look at as an investor is a property’s cap rate. This is your return on investment if you were to pay all cash, also called the unlevered return.
Let’s take a look at this property. If you were to invest $1,200,000 of cash into a property that earns $96,000 annually, you are expecting an 8% annual return on your investment. Now, if you were to apply for acquisition financing of $850,000, you will only need to invest $350,000. Factoring in annual payments for principal and interest, your net proceeds come out to $50,000 which earns you 14% of your initial equity investment. This is what we call the levered return.
At first glance, a property may only be yielding an 8% cap rate, but with financing options, you can improve these returns at 14%.
Applying for financing can dramatically improve returns on your potential investments. It is now more important than ever to work with brokers who understand the impact of financing as they can make or break the deal.
Author: Irene Uy
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