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Capitalization rate
For long-term investors who plan to hold the property, Crowe uses the capitalization-rate or cap-rate formula. The cap rate is defined as the ratio of yearly net income to the value of the property. It is expressed as follows:

Capitalization-rate formula

Formula: Annual rental income (income - expenses, not including mortgage)/ the purchase price = capitalization rate. Example: If you purchase an investment property for $120,000 and it can generate $1,000 per month after operating expenses (not including the mortgage), then the cap rate would be $12,000 divided by $120,000, or 10 percent. This means it will take approximately 10 years to recoup the property value in net rental income if the rent stays the same (10 years at 10 percent = 100 percent). If the cap rate were 5 percent, it would take 20 years (20 years at 5 percent = 100 percent) to recoup the value.

The cap rate offers a way to compare deals based on the value of the property regardless of the amount of down payment or the interest rate on the loan. While higher mortgage payments would change the return on investment, Crowe says, "It doesn't change the cap rate."

If you're selling a property, says Crowe, "It's better to have a buyer willing to accept a lower cap rate. But if I'm buying, I want a high cap rate." For instance, if you buy a property with a cap rate of 8 percent and did nothing to it but raise the price, the cap rate drops to 7 percent. You've made a profit.

Cap rates vary, depending on the region in which you are investing.

"In the Midwest region a cap rate of 7 percent or 8 percent is considered good," says Crowe.

On the coasts, a cap rate of 6 percent is more common. A decade ago a 10 percent cap rate was customary, says Crowe, who offers real estate investment advice on his Web site www.dougcrowe.com. Crowe has invested in real estate for about 19 years and taught investing in Chicago for about five years.