What Is the Capitalization Rate in Real Estate?
What Is the Capitalization Rate?
This is the most popular measure through which real estate investments are assessed for their profitability and return potential. The capitalization rate (commonly known as cap rate) is used in the world of commercial real estate to indicate the rate of return is expected to be generated on a real estate investment property.
The cap rate simply represents the yield of a property over a one-year time horizon, assuming the property is purchased for cash and not on a loan.
Formula for the Capitalization Rate
In the most popular formula, the capitalization rate of a real estate investment is calculated by dividing the property's Net Operating Income by the the current Market Value.
Mathematically,
Capitalization Rate = Net Operating Income / Current Market Value
Where,
The net operating income is the (expected) annual income generated by the property (like rental) and is arrived at by deducting all the expenses incurred for managing the property. These expenses include the cost paid towards the regular upkeep of the property, as well as the property taxes.
The current market value of the asset is the present-day value of the property, as per the prevailing market rates.
In another version, the figure is computed based on the original capital cost, or the acquisition cost of a property.
For example: a $100,000 net income with a cap rate of 5.00% equates to $2,000,000. Therefore, a cap rate of 5.00% will take around 20 years to recover the initial $100,000 investment.
Peter Flynn, Director, Intercommercial Property Advisers
M: 0418 129 299
