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The capitalization rate more known as the cap rate in the real estate industry is used by investors to indicate the rate of return that one may receive on a potential investment opportunity. This is what a potential investor perceives the property to make as in net income.
The Cap rate is calculated by taking the property's supposed net operating income (NOI) divided by the proposed current market value of the property, or by dividing the purchase price by the current property's net operating income (NOI). This is a quick use of calculating the investor's POTENTIAL return on investment in their proposed real estate market.
The cap rate should not be the only form of calculating a potential investment's value, or return on investment (ROI). The cap rate largely depends on the supply and demand of a market, and every market is different depending on where the investor is investing, and the state of that local economy, so the investor should know the market well that they are investing in. This is why it is strongly encouraged that new investors begin in their backyard, basically their own local economy.
Here is some more detailed information on cap rates.
"Capitalization Rate = Net Operating Income / Current Market Value
where,
The net operating income is the (expected) annual income generated by the property (like rentals) 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 facility 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.
Capitalization Rate = Net Operating Income / Purchase Price
However, the second version is not very popular for two reasons. First, it gives unrealistic results for old properties that were purchased several years/decades ago at low prices, and second, it cannot be applied to the inherited property as their purchase price is zero making the division impossible.
Additionally, since property prices fluctuate widely, the first version using the current market price is a more accurate representation as compared to the second one which uses the fixed value original purchase price." Source: (https://www.investopedia.com/terms/c/capitalizationrate.asp)
Written by JAMES CHEN Updated June 29, 2020
Reviewed by JULIUS MANSA
Fact checked by ARIEL COURAGE
Source: (https://www.wikihow.com/Figure-Cap-Rate)
Now that you know about cap rate, use it in your own evaluation of potential investment opportunities that you may want to invest in.
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