Capitalization Rate: Definition, Formula, Importance, And More
The capitalization rate is a rate with the help of which you will be able to evaluate whether a given investment is good or not. It basically shows you the potential of return on the investment.
It has most applications in the real estate industry, where it gives you an idea of the rate of return that can be generated out of a real estate property. You can use this rate to compare the relative value of similar real estate investments.
In this article, you will learn about what capitalization rate is in the context of real estate. Apart from that, you will also learn about how to calculate the capitalization rate of any real estate using the formula. In addition to that, you will also learn about how this rate works and its huge importance in real estate.
Finally, we will discuss some of the major pros and cons of capitalization rates. Hence, to learn more, read on through to the end of the article.
What Is Capitalization Rate?
According to Investopedia, “The capitalization rate (also known as cap rate) is used in the world of commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property. This measure is computed based on the net income which the property is expected to generate and is calculated by dividing net operating income by property asset value and is expressed as a percentage.”
With the help of this measurement, you can determine the potential investment return on a property in the real estate market. This shall then allow you to get an idea of various real estate properties as you can compare their rates of returns. The cap rate basically gives you the relative value of similar real estate investments.
However, you must also know that you cannot use this rate as a sole indicator to determine the strength of an investment since it does not take into account other factors. Some of the factors that are important to consider in addition to the cap rate are – leverage, time value of money, future cash flow from the given property, and many more.
Capitalization Rate Formula: How To Calculate It?
Here is the formula with which you can calculate the cap rate of any investment:
| Capitalization Rate of an Investment Property= Net Operating Income (NOI) / Market Value of the Asset |
Here, Net Operating Income (NOI) = Rent of the property – Maintenance Expenses paid for it
You can also consider the cap rate as a return on investment you will receive annually after you purchase the real estate property. However, there are other factors to consider as well if the cash flow is irregular, as discussed before.
What Is The Importance Of Capitalization Rate In Real Estate?
The Wall Street Mojo adds – “Capitalization rates can be a good estimate to compare different investment properties. But a higher rate does not usually mean a better investment opportunity. Cap rates are important, but an investor needs to look into other parameters. It can be considered as a measure of the riskiness of the investment. Usually, a low rate implies low risk, and a higher rate indicates higher risk.”
You must also know that cap rates can vary a lot since they are based on the projected estimates of future income. Hence, it becomes important to understand what is a good cap rate for an investment property. Also, different cap rates across different time horizons on the same property might represent different risk levels.
According to Investopedia, “The foremost use of the capitalization rate is to discriminate between different investment opportunities. If a security investment offers an estimated 4% return and a property has a capitalization rate of 8%, an investor is likely to focus on the property. Capitalization rates can also form trends for commercial property owners.”
With the help of trends, you will have a better idea of where the market is heading. This shall allow you to make adjustments based on estimated rents.
What Are The Pros And Cons Of Capitalization Rate?
The following are the major pros and cons of capitalization rate in business and investment:
Pros Of Capitalization Rate
Here are the major pros of capitalization rate that will benefit you:
- You can compare the potential of different real estate investment options. If there are properties with different rates of return, you can then find the best one for yourself.
- You can also take the benefit from the trends. If the rental rates of real estate are about to increase, you will be able to make the most of them.
- You can use the cap rate as a support metric in addition to other ones to do a cash flow analysis of the property and more.
Cons Of Capitalization Rate
Here are a few cons of capitalization rate which you must be aware of:
- You can use the cap rate only when the net operating income is constant and does not fluctuate a lot.
- If the cash flow is complex and irregular, you will need to use a fully discounted cash flow to find out the cap rate of the investment.
- Although you can get an idea of various factors, you still cannot have information on future risks. By using the cap rate, you are assuming sustainable income from the concerned real estate property.
Final Thoughts
You will need the capitalization rate to measure the profitability of commercial rental properties. If a property has a high cap rate, it shows that there is a likelihood of a high income, as compared to the size of the investment. However, you will also need to consider other factors, like risks and market dynamics, before you make a decision on real estate.
Despite that, there is also a limit to the usage of the capitalization rate. For example, if a real estate property has irregular or complicated cash flows, you cannot afford to rely only on its capitalization rate. Do you have any suggestions on how to apply cap rates in real estate? Share your ideas with us in the comments section below.
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