The capitalization rate is a formula used by investors that indicates the expected return to be received on a real estate investment. For all investors, this formula plays an essential role as it helps to understand if the investment will give a consistent income.
The investors apply this formula to choose in which real estate to invest. For example, you have to decide whether to invest in a $400,000 building or $500,000 building. It is a bad idea to choose to buy a building at a lower price. What is vital is to know which one will bring more profit to the investor.
This formula also shows how soon an investor will receive his money back.
What is a cap rate formula?
In general, the cap rate formula is net operating income divided by the current real estate price. Net operating income is the expected income that property will bring in a year, minus all the expenses related to property. For example, you have a business space, and the tenant pays $ 3,000 per month. Then, your net operating income is $36,000 per year without deducting any expenses. These expenses may be insurance, taxes, and maintenance cost. How much fees you will pay depends on the terms of a lease agreement.
Let’s imagine that you are going to buy a $500,000 property. Its operating income is $35,000. In such a case, the capitalization rate will be 7%.
The capitalization formula is calculated as a percentage, so we need to multiply 0,07 by 100. Then we receive a 7% capitalization.
So, this tool is helpful when comparing two or more properties to invest.
What is a reasonable cap rate?
As a rule, a cap number between four and ten percent seems to be good. Nevertheless, having a reasonable cap rate is not enough to make a decision. There are additional factors that affect — for example, location, property type, supply, and demand ratio.
Location is vital in terms of commercial real estate. You can change how the real estate looks, even its size, but you can never change the location.
What type of property are you going to invest in? Industrial, rental, multifamily? The residential property looks like a more safe investment because people always need a place to live. That is why the commercial property has lower capitalization rates, while commercial property still has higher rates because of risks associated with it.
Supply and Demand Ratio
For you, it is essential to know how many competitors you have in the area. You can earn nothing if many other landlords are willing to reduce the rental fees.
It seems evident that investors want a high cap rate. The higher the rate, the better, right? Not exactly. So, a high cap rate means the low cost of property comparing to net operating income. However, the higher the cap rate, the higher the risks. So vice versa – the lower cap rate, the lower risks. That is why you need to understand how much risk you can tolerate.
Knowing only the number of the capitalization rate is not enough to know whether to invest or not. You should see the property context. If the property stays on the market for a long time, there might have been reasons for that.
So, a capitalization rate is an excellent tool for real estate investors to the bigger picture. However, it does not reflect the whole picture. To make the right decision, an investor has to analyze all the factors and not only if the capitalization rate is high enough or not.