What’s the formula for cap rate? What are its implications for real estate investors? And what relationship does it have with the equity dividend rate? If you are interested in real estate investing, these are the right questions to ask yourself.
Typically, when investing in real estate, you need to consider the rate of return of your investment. In addition, you need to compare how one property’s profitability measures up against other properties you are considering. Your goal is to avoid buying real estate whose returns are very low.
Therefore, you need to use several metrics to determine whether a property is worth buying or not. And that’s where cap rate and equity dividend rate calculations come in.
What Is Equity Dividend Rate?
The equity dividend rate is the ratio of the cash you receive in a given year to the cash you invest in the property. The result is then multiplied by 100 percent.
In this case, the cash you invest is not always the sale price. It could be more or less than the purchase price, depending on whether you bought the real estate completely in cash, paid for renovations or used debt to finance part of the purchase. On the other hand, the cash you receive refers to the pre-tax cash flow, which includes all property-related income minus all the property-related expenses for a given period.
If you are looking for excellent real estate deals, consider an equity dividend rate of anywhere from six to 12 percent. And anything higher than that is excellent. People also refer to the rate as a cash-on-cash return.
1. Equity Dividend Rate Formula
The equity dividend rate formula in real estate is:
Equity Dividend Rate = Annual Cash Received/Annual Cash Invested
However, you need to understand the difference between annual cash received on a levered basis and the cash received on an unlevered basis.
2. Annual Cash Received: Levered vs. Unlevered Basis
When you use annual cash received on a levered basis, your equity dividend calculations will produce a different answer compared to when you use annual cash received on an unlevered basis. So, what is the difference?
Well, you first need to understand debt leveraging. The process refers to borrowing money to finance the purchase of real estate for investment purposes, thus reducing your risk. So, when you consider annual cash received on a levered basis, you consider the cash flow after deducting the debt repayments. On the other hand, cash received on unlevered basis refers to the net operating income, which is equal to gross income minus operating expenses.
It is also worth noting that the cash invested on a levered basis refers to the down payment you pay, plus any other expenses you incur to make the house rentable. However, the cash invested on an unlevered basis refers to the sale price plus any other expenses you incur.
Read More: Objectives in Real Estate Investing
3. How to Solve For Equity Dividend Rate
Below are the steps to take when performing equity dividend calculations to obtain the rate.
- Consider all the income you have received from a property you bought using a loan and rented out. That includes the rental income and additional monies from income streams such as parking fees, laundry services, etc. The sum of all these incomes is known as the gross income. For example, suppose you own a three-bedroom home that brings in $48,000 a year in rental income plus $12,000 in other income. In that case, your gross income is $60,000.
- Note down all the operating expenses associated with your investment property, such as maintenance fees, property taxes, renovation costs, utilities and insurance, among others. Considering the above example, assume the operating expenses amount to $14,000 per year.
- Subtract the operating expenses from your gross income to get the net operating income (NOI). In this case, your NOI will be $46,000.
- Subtract all the debt-related expenses from your NOI to come up with the pre-tax cash flow. Suppose you are required to pay $12,000 a year in mortgage-related expenses. In that case, your pre-tax cash flow will be $46,000-$12,000, which is $34,000.
- Now, consider the cash you invested in paying the down payment and what you spent to make it rentable and add everything up. Assume you spent $280,000 in this case.
- Divide the pre-tax cash flow by the cash invested and multiply by 100 percent. Based on this example, you will divide $34,000 by $280,000 and multiply by 100 percent, which will equal 12.14 percent. That result represents your equity dividend rate.
Equity Dividend Rate vs. Cap Rate
Cap rate, or capitalization rate, is the ratio of the net operating income to the current market value of the property you invest in. The resulting value is then multiplied by 100 percent to obtain the percentage rate.
It is similar to the equity dividend rate in that it uses the net income to arrive at the final value. But it differs from cash-on-cash returns because it considers the actual market value of a property instead of the cash invested. The latter may be more or less than the market value and represents what you spend from your own pocket.
Generally, the higher the cap rate, the more profitable the property is likely to be if the income remains steady. However, higher values also imply higher risks you need to undertake when purchasing the property.
It is best to use multiple valuation metrics to determine the true value of an investment property. While doing so, consider how much risk you are willing to tolerate.
- The equity dividend rate measures the annual return on your cash investment before the effects of income taxes, which could reduce your returns.
I hold a BS in Computer Science and have been a freelance writer since 2011. When I am not writing, I enjoy reading, watching cooking and lifestyle shows, and fantasizing about world travels.