How Much to Spend on an Investment Property Vs. the Potential Rental Income

The capitalization rate is the market rate of return that's commonly used to score similar properties in a market. On an investment property, the capitalization rate -- commonly called the "cap rate" in real estate-speak -- is simply the annual net rental income divided by the price paid for the property. So if you pay $1 million for a commercial property and lease it, less expenses, for about $100,000 per year, your cap rate is a very respectable 10 percent. Calculating an acceptable purchase price of a property using the cap rate requires two data inputs: net operating income and the cap rate. For example, if the net operating income is $25,000 and the cap rate is 10 percent, the desired purchase price would be $250,000 ($25,000 / 0.10).

Most real estate agents know the typical cap rates for commercial and multifamily residential properties in your market. Cap rates for single-family houses are not easily obtained except in Internet chat rooms. If you're in doubt, use real estate comparables obtained from your real estate agent. When doing so, be prudent by exploring different scenarios using low-end and high-end comparables to ensure the property offers the potential for a sufficient return on your investment.

An accurate estimate of net operating income is vital to arriving at a meaningful purchase price for investment real estate. Follow these steps to identify net operating income:

Compute the net rental income. Do this by reducing your expected gross rental receipts by the frequency of historical vacancies. Inquire with the property seller, your real estate agent and other knowledgeable sources for historical vacancies. For example, if each unit in your property is typically vacant one month out of each year, you would reduce your annual income estimate by 1 divided by 12, or 8.33 percent.

Determine your operating expenses. These include taxes, insurance, utilities and property management. Exclude your mortgage payment because this is not an operating expense.

Compute your net operating income. Do this by subtracting your operating expenses from your net income. Your net operating income indicates what's available for paying the mortgage.

Doing the diligence of an absolute valuation is required to assess the time value of your money relative to your cost of borrowing. Discounted cash flow and internal rate of return are the principal metrics used in absolute valuations. Discounted cash flow converts future incoming and outgoing cash flows from your investment to a net present value using an appropriate discount rate. If the net present value exceeds your initial investment, you will have a positive cash flow. Your ideal investment generates the greatest positive cash flow.

Internal rate of return captures both the return of your original investment and the return on your investment in computing the overall yield on your investment. The investment that generates the highest internal rate of return beyond your cost of borrowing is the better investment.

Real estate investing requires serious number-crunching. Fortunately, a number of free calculators are available online and embedded in spreadsheet software for higher level number-crunching, such as discounted cash flows and internal rates of return. For example, Bankrate.com has real estate calculators for numerous applications.