What is the capitalization rate?
Definition: The capitalization rate, also known as cap rate, is a term used to describe the expected rate of return on a real estate investment property.
The most significant element to understand when it comes to capitalization rates is that real estate investors use cap rates to help determine whether they should invest in a property. To calculate the capitalization rate, investors use the cap rate formula, which includes the annual net operating income (NOI) of the property and its current market value.
Essentially, the cap rate formula is simply the NOI divided by the property value or asking price. It’s important to keep in mind that the NOI can increase once improvements have been made to the property. The property value or asking rate also has some volatility because it tends to be influenced by outside factors like the state of the economy and regional property demands.
What is a good cap rate?
Overall, a higher capitalization is considered to be a good cap rate. However, what is considered a “good cap rate” will vary across different types of properties. Common property types include single-family investment properties, condos or townhomes, multifamily rental properties, apartment buildings, and commercial real estate.
Capitalization rate case study
The following examples serve as a case study for capitalization rates in action. To find the capitalization rate, an investor will need to use the following formula:
Capitalization rate = net operating income / current market value
Suppose an investor is looking at two different properties and wants to determine which property has the better financial potential. This investor can use the cap rate formula to see which of the two properties is likely to provide a return on their investment more quickly.
Property A is determined to have a value of $350,000, a gross rental income of $50,000, and operating expenses of $15,000.
Cap Rate of Property A = ($50,000 – $15,000) / $350,000 = 0.1 or 10%
Property B is determined to have a value of $350,000, a gross rental income of $60,000, and operating expenses of $30,000.
Cap Rate of Property B = ($60,000 – $30,000) / $350,000 = 0.09 or 9%
Based on these case study examples, the investor would likely choose to purchase Property A as they will likely be able to see a return on their investment faster.
The bottom line
When it comes to capitalization rate, the bottom line is that they help investors better determine the profitability of potential real estate investment properties. While cap rates are not always completely correct, as there is some variability in the property’s NOI, they provide investors with a solid prediction of how fast they will be able to see a return on their real estate investment property.