What are Capitalization Rates?

The capitalization rate or cap rate for short, is a rate of return metric commonly used in the real estate industry for income producing properties. While often overlooked by smaller-scale investors, cap rates are an important metric when evaluating all investment opportunities – small and large. cap rates can can help an investor determine if an opportunity will provide the desired rate of return. They are also useful in comparing one property investment opportunities to another.

The formula for a cap rate is simply the net operating income of the property divided by its current market value:

Capitalization Rate = Net Operating Income / Current Market Value

Net operating income (NOI) is the income that the property produces through collecting rent and other income from tenants such as parking fees and laundry, minus the expenses required to operate the property. These expenses include utilities, maintenance, property taxes, insurance, etc. Net operating income does not include financing or personal income tax, as these are expenses that are specific to the individual(s) purchasing the property and are not costs incurred from operating the property.

Cap Rate Example: If a property has net operating income of $63,000 and its current market value is $890,000, then we can divide the net operating income by the current market value of the property to determine the property’s cap rate. Doing so will give us a cap rate of approximately 7.1%:

$63,000 / $890,000 = 7.1%

This formula can be reconfigured when trying to determine the current market value or the NOI required to achieve a certain cap rate, assuming you have two of the three variables.

Generally, the more risky the investment is, the higher the cap rate will be since investors want to be properly compensated for taking on this risk. Overtime, cap rates may change based on the rate rate of return that is desired by investors. When cap rates increase, property values decrease. Vice versa, when cap rates decrease, property values increase.

If you have questions on cap rates or want us to cover any other real estate investment returns metrics, feel free to send us a message by filling out the contact form below!

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