Real Estate Investing
Capitalization Rate: What It Is and How To Calculate It
Last Updated Aug 23, 2022
Table of Contents
- What is capitalization rate?
- Capitalization rate formulas
- Capitalization rate example
- How to use capitalization rates to your benefit
- How Belong supports the success of your real estate investments
The capitalization rate is one of many ways to evaluate a potential investment property. Still, it’s critical to understand how capitalization or cap rates are calculated and their limitations. With a better understanding of calculations like cap rates, you can identify the best methods for assessing a potential rental property.
What is capitalization rate?
Capitalization rates compare and estimate the future return on investment or ROI of one or more real estate properties. Cap rates for residential and commercial real estate are expressed as a percentage. They’re a popular tool because they help individuals estimate the potential return on real estate investments.
Capitalization rates measure the potential yield of a specific real estate property over one year, assuming that the property is not financed. You can also think of cap rates as the percentage rate of return, either a loss or gain, of a specific property based on the income it generates, minus expenses.
Capitalization rate formulas
How do you calculate the capitalization rate of a property? There are two methods or formulas that are used to calculate capitalization rates.
Most real estate investors will use the calculation which divides the net operating income by the property’s current market value. This calculation can be expressed using this formula:
Capitalization Rate = Net Operating Income / Current Market Value
In this calculation, the net operating income equals the estimated annual income minus expenses like maintenance, property management, and property taxes. This formula is most popular because it compares the projected income of a property against the current market value.
The second formula used to calculate capitalization rates differs because it compares net operating income against the property’s purchase price.
Capitalization Rate = Net Operating Income / Purchase Price
This formula puts more emphasis on the acquisition cost of a specific property, as opposed to the current value of a property. While there is no drawback to using this formula at the time of purchase, it’s not ideal for properties purchased months or years prior. Using the purchase price from several months or years ago will incorrectly estimate a property’s potential return. Similarly, this formula works poorly for homes that have been inherited because the purchase price is zero. As a result, using this formula can result in unrealistic expectations.
How to calculate net operating income
To estimate the net operating income of a property, you will need to calculate the annual rent by multiplying the monthly rent by twelve. Once you have calculated the annual rent, you will need to subtract expenses. Expenses should include taxes, utilities (if not paid by the resident), property and liability insurance, and maintenance.
If you are unsure of the monthly rent, we recommend that you research similar properties in the same area. You’ll need to look for other properties that have similar amenities. Identifying several similar properties will help you accurately estimate your monthly rent for a property.
Why don’t the capitalization rate formulas account for financing
Capitalization rates do not account for property acquisition costs like interest and closing costs for a very specific reason. The cost of acquiring a property will vary significantly depending on current interest rates, type of loan, and your particular closing costs. While other formulas can account for these costs, capitalization rates are designed to provide a baseline rate of return, regardless of loan repayment or interest rates. Excluding acquisition costs ensures that investors compare potential properties based on possible returns without factoring in highly variable costs unique to each individual.
When you shouldn’t use capitalization rates to assess real estate properties
You should not use capitalization rates to evaluate a property if you plan to use the property as a vacation or short-term rental. The potential income, occupancy, and expenses are too variable to assess a property accurately.
Capitalization rate example
While capitalization rates are a helpful tool, they have limitations that can be illustrated using two hypothetical properties. Let’s imagine that the first property has a net operating income of $50,000 and the current market value of the property is $600,000. In this example, the capitalization rate is 8%.
Property #1 = ($50,000 / $600,000) x 100% = 8%
In the second example, a property has a net operating income of $40,000 and is currently valued at $400,000. The capitalization rate for this property is 10%.
Property #2 = ($40,000 / $400,000) x 100% = 10%
If you only consider capitalization rates, the second property is the better investment. However, each investment opportunity has unique characteristics that should be considered. While the second property has a better capitalization rate on paper, it could be located in a less desirable location or have fewer amenities. As a result, the first property might be a better investment, even if it has a lower cap rate.
How to use capitalization rates to your benefit
Capitalization rates are one tool for gathering information and comparing potential rental properties. Individuals can identify the best investment for their financial picture and goals with more details.
When calculated correctly, capitalization rates can indicate the length of time needed to recover the amount invested into the property. For example, a cap rate of 10% will require around ten years to recover the amount invested in the property.
Understanding what constitutes a ‘good’ cap rate
It may be tempting to look for a potential investment property with “good cap rates.” However, it’s essential to understand that capitalization rates are not evaluated as good or bad but rather as an expression of potential risk.
What are normal capitalization rates
A higher capitalization rate corresponds to more risk, and a lower cap rate is associated with less risk. Your ideal cap rate will depend on how much risk you’re comfortable taking. Generally, capitalization rates will fall somewhere between 4% and 10%.
You should assess capitalization rates in the context of the specific property and the current real estate market. As a general rule, you can expect capitalization rates to increase whenever interest rates rise. An increase in interest and capitalization rates will significantly impact anyone who owns a rental property.
All things being equal, a lower cap rate equates to a better valuation and a better prospect of returns with less risk. Conversely, a higher cap rate will likely result in a relatively lower ROI and a higher level of risk.
In real estate, properties are rarely equal. One property may generate more rental income but has more maintenance costs and higher taxes. Ideally, you want to identify a property with a reasonable cap rate relative to the amount of risk in purchasing a specific property.
How Belong supports the success of your real estate investments
A successful real estate investment strategy requires you to identify the ideal property, maintain a positive cash flow, and manage the investment effectively. Belong helps homeowners increase their profits and limit the hassles of owning an investment property.
When it’s time to price your property, Belong uses data and real-time insights to help you maximize cash flow. We also offer guaranteed rent, which means you never worry about less than 100% occupancy, which helps keep your investment safe.
About the author
Jordan Newsom is a highly-caffeinated writer who loves delighting readers, using content to teach, and broadening perspectives. When she's not behind a computer screen, she's hunting down the best coffee shops, breweries, and restaurant patios in Denver, Colorado.