What is Capitalization Rate?

A capitalization rate, or cap rate, is used by real estate investors to evaluate an investment property and show its potential rate of return, helping the investor decide if she should purchase the property. The formula is: Net Income / Total cost of acquisition Net Income = Revenue - Operating expenses This indicator is commonly used in the evaluation of real estate, but it can be used for other assets in the same way. The capitalization rate of an investment may be slightly different from one investor to another, and determining its exact value requires a deep understanding about how you will pay for certain operating costs such as repairs or administration.

How Does Capitalization Rate Work?

To calculate the capitalization rate of a property, you must know the net income that the property will generate in a year. The net operating income of a property is the money that you will have after subtracting fixed and variable operational costs from the gross income obtained by rent or percentage sales. Fixed costs generally include mortgage interest, insurance, property taxes, or property management fees. Variable costs may include items such as expected repairs or vacancy rates. Next, you need to know what you pay to acquire the investment property. Remember, if you need to take a loan to acquire property (like many people), the interest on your mortgage should be taken into account within the cost of maintaining the property, even if the capitalization rate is not affected. Because many operational costs may vary from one investor to another, the capitalization rates for the same property may also vary. For example, a real estate investor who understands the construction of houses and makes repairs on their own can assume lower repair costs than an investor who hires these jobs with someone else. Similarly, if you are planning to perform property administration on your own, your cost for this service will be US $ 0, while someone looking to outsource this function will have to pay a percentage of the monthly rental income, reducing the rate of capitalization of property.

Example of Calculating the Capitalization Rate

Suppose an investment property is for sale for US $ 100,000. The tenants of the property have a contract for one year, which requires payment of US $ 1,000 per month, so the gross income for this property is US $ 12,000 per year. Suppose the annual property taxes are US $ 1,000; the property will need $2,000 in improvements over the next year; insurance costs US $ 800 per year; and a property manager agreed to manage this property for an annual price of US $ 2,000. The total operational costs would be US $ 1,000 + US $ 2,000 + US $ 800 + US $ 2,000 = US $5,800. The net operating income would be US $ 12,000 - US $ 5,800 = US $ 6,200. The capitalization rate would be US $6,200 / US $ 100,000 = 6.2%.