What is the Capitalization Rate (Cap Rate) and how to use it to evaluate real estate investments?
The capitalization rate (Cap Rate) is one of the tools every real estate investor must know how to utilize if he wants to be successful in the real estate industry. The capitalization rate means the rate of return that is expected to be generated on a real estate investment property. In simple terms, the cap rate is known to be the most popular measure which is used to calculate the profit and return on investment.
A cap rate is calculated as the ratio between the net operating income generated by an asset and its original capital cost. The formula for calculating capitalization rate is as follows;
Capitalization rate = annual net operating income
cost value (of a property)
For instance, if a property is worth $200,000 and it generates $20,000 positive net operating income (i.e. the amount left after the removal of the fixed cost and variable cost) over a specific period usually a year, the capitalization rate would be;
Capitalization rate = $20.000 = 0.10 = 10%
$200,000
Thus, the cap rate for the example stated above is 10%. However, it should be noted that the calculation of the cap rate is done annually, which means the 10% cap rate is for one year. The cap rate of a property can vary every year and can also remain static depending on the net operating income generated annually.
How to use a cap rate to evaluate real estate investment
The cap rate can be used to evaluate real estate investment and to know whether it’s a good deal or not. It is usually used before buying a property, and this will aid the decision of a real estate investor whether to invest in such property or not.
Using the cap rate to evaluate your real estate investment is determined by knowing whether the property has a good cap rate or a bad cap rate.
What is a good cap rate?
A cap rate is said to be good when it falls between 4-10%. However, it should be noted that the cap rate varies based on location. For instance, in a high demand location, 4% cap rate may be the usual rate and may not necessarily mean a good cap rate while in a low demand location, 10% cap rate or higher may be the ideal rate.
Nevertheless, it’s advisable not to opt for a real estate investment whose cap rate is high. Investments with a high cap rate mean it is situated in an area where there is a low chance of an increase in the rents rates and also where there is a slim chance of the property appreciating.
This means every real estate investor must opt to invest in properties with a low cap rate because the higher the cap rates, the higher the risk and depreciation while the lower the cap rate, the lower the risk and depreciation.
Knowing how to calculate a cap rate is what every investor should make a top priority if he wants to stay for long and successful in the real estate industry. Once a real estate investor is a master in this, chances of investing in properties with high returns are high.
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