The capitalization rate (or cap rate, in short) is a metric used in real estate to indicate the potential rate of return from an investment property. It is calculated based on the net income the property is expected to generate. The formula is spelled as follows:
Capitalization Rate = Net Operating Income / Current Market Value
The Net Operating Income is essentially the difference between revenue and operating expenses. It does not include principal and interest payments on loans or capital expenditures. Assuming you own a rental property that pulls in $100,000 in total annual revenue and incurs $65,000 in maintenance costs and taxes, your NOI will be $35,000.
To calculate your cap rate, you will divide the $65,000 by the property’s current value. Supposing the property is valued at $500,000, then the cap rate will be 0.07 or 7%. This percentage is used as an indicator of the return you can expect on an investment. In contrast, if the cap rate on a similar rental property is only 2%, that means that the one projected at 7% would be more profitable and produce the highest return.
In addition to profit, the rate also indicates the duration of time it will take to recover the invested amount in a property. For instance, with a property whose cap rate is 10%, you would divide 100 by the cap rate. In this case, it would amount to a 10-year payback period.
While a higher cap rate may seem like the obvious choice, it is also understood as a measure of risk. With higher cap rates, there is a greater risk of not getting the return you expect, and perhaps not getting your investment back. As a best practice, use this metric to gauge comparable homes in a same neighborhood and beware of cap rates that are irresistibly high.
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