Question

1. Rick is looking to purchase a rental house at below market value, so he receives advice from his real estate broker, Dopey. Dopey explains it is smart to obtain a property between a 3 - 6 percent capitalization rate. Dopey suggested that Rick research the existing neighboring properties and determine the average price. Rick got three appraisals for neighboring properties: $500,000, $450,000, and $375,000. The home he wants to purchase has net operating income of $27,500 with a cap rate of 5.0%. Would this be a good deal for Rick? If so, why. If not why.

        

Answer 1

Rick is looking to purchase a rental house at below market value. So, he would like to pay less for a house worth more.

Now, cap rate or capitalization rate is defined as net operating income that the real estate investment can make divided by the current market value of the property. This ratio gives an idea to the investor about his potential earnings from a real estate investment. It is useful incomparing nearby real estates. Similar properties in nerby areas are expected to have similar cap rates.

Capitalization rate = Net operating income/Current market value

Net operating income of the home he wants to purchase = $27,500

Cap rate = 5%

Thus, the property price = 27500/0.05 = $550,000

If we compare it with neighbouring properties, we can see that the cost for this house is high. The average price of neighbourhood properties = (500,000+450,000+375,000)/3 = $441,666.67

Thus the price of the house he is looking to buy is higher than its neighbourhood.

This does not correspond with his initial requirements as he wants to buy a house at below market value.

Thus, this investment is not good for Rick.