Capitalization rate (also called cap rate) is used in the real estate industry to indicate the return of investment expected on a real estate investment property. In more straightforward terms, cap rates are return metrics used to determine potential returns on investments or capital payback.
While cap rates can be useful in quickly comparing relative values of similar real estate investments in the market, it shouldn’t be the sole source of an investment’s strength; it doesn’t consider the leverage of an account. There are no ranges to excellent or bad cap rates as it largely depends on the property and market context.
Below, we’ll be giving concise explanations on how you can better understand capitalization rates, their importance, and using the right cap rate calculator formula:
Understanding Capitalization Rate
Capitalization rates are the most popular measure for calculating profitability and return potential on real estate investments. The cap rate represents the property’s yield over a year, assuming the property was bought with cash and not through a loan. Cap rates, therefore, uncover the property’s natural, intrinsic, and unleveraged return rate.
The Formula for Calculating Capitalization Rate
Different formulas can be used when calculating cap rates. In the most popular procedure, the cap rate is obtained by dividing the net operating income of the property by its value in the real estate market.
Cap Rate = Operating Income/Current Market Value
The net operating income refers to income expected from the property annually, and this is achieved by deducting all the expenses incurred from managing the property. These expenses are the total cost paid to maintain the property as well as the property taxes.
On the other hand, the current market value refers to the present-day value in conjunction with the ever-changing market rates.
In another formula version, figures are generated based on the property’s original capital or acquisition cost.
Cap Rate = Operating Income/ Total Purchase Price
This second formula isn’t famous for two primary reasons. Firstly, it gives unrealistic results for old properties purchased long ago at low prices. Second, it can never be applied to inherited properties as their purchase price is zero, making it impossible to divide.
Furthermore, since the fluctuation of property prices is typical, the first version gives a more accurate representation of the current market price instead of the second version that uses the original purchase price’s fixed values to compute.
What is a Good Cap Rate for Rental Property?
What is a good cap rate? A good cap rate always hovers around 4%. However, it is essential to differentiate between a “good” cap rate and a “safe” cap rate as these terms are similar. The formula above puts net operating income to the initial purchase price. Investors, therefore, hope that their lower purchase price deals may yield a high cap rate. Following this logic, cap rates between four to ten percent are considered “good” investments.
However, cap rates have increasingly become synonymous with a risk evaluation. To determine if a cap rate is “safe,” identifying the level of risk you’re comfortable exposing to is crucial. A lower cap rate implies lower risks in more succinct terms, while a higher cap rate implies higher risks. Most investors looking to play it safe usually go for a lower cap rate. Consequently, it would be best if you never take more risks than the ones you can comfortably handle.
How to Calculate a Stabilized Cap Data
How can you calculate a stabilized cap data? It’s pretty straightforward and easy. Stabilized cap data reflects future improvements. These improvements would not only allow you to increase the rent but will also increase the property value.
To calculate a stabilized cap data, you’ll need to divide the new net operating income by your property’s current market value.
Although it results in higher risks, it improves returns for your property.
Importance of Capitalization Rates Calculations
Capitalization rates are used to compare different investment opportunities. For example, if a property has a cap rate of 10% and another property has a cap rate of 3%, an investor is most likely to face the property with a 10% cap rate.
Cap rate also determines the amount of time it takes to recover an investment property. If a property comes with a 9% cap rate, it will take an investor nine years to recover his investment.
Capitalization rates are vital in trend formation for commercial property owners. Trends can show where the markets are headed, allowing for adjustments that are based on estimated rent.
Examples of Capitalization Rates
Let’s assume that there’s an investor with a capital of $1 million who’s considering investing in one of two available investment options. One is investing in government treasury bonds that offer a 3 percent interest rate annually and is regarded as the safest option. Two, one can purchase a commercial property with tenants that pay regular rent.
In the second case, let’s assume that rent is fixed at $90,000 a year, and the investor needs to pay a total of $20,000 in maintenance and property taxes. Therefore, the net income of that property is valued at $70,000. If that occurs during the first year, that property value remains at the original purchase price of $1 million.
For this the capitalization rate is calculated by (Net Operating Income/ property value × 100) = $70,000/ $1,000,000 which equals to 7%.
This return of 7 percent generated from this property is way better than the 3 percent he would have gotten from treasury bonds. The extra 4 percent represents the return of the investor’s risk as against investing in treasury bonds that came with zero risks.
Varying income levels generated from the property, expenses related to the property, and the current market value can significantly change the cap rate.
- Surplus returns happen as a result of the investor being able to take risks. These risk factors include:
- Age, size, and location of the property
- Property type
- Terms and structure of tenants leases
- The market value of the property and factors affecting its valuation
The need for a cap rate ROI calculator is essential in the proper evaluation of a property, as they are required to calculate occupancy rates, capex amounts, and maintenance fees. Getting answers helps the investor view market conditions and make either conservative or aggressive changes.