In real estate, the capitalization rate is one of the most useful financial metrics you should track. The capitalization rate is ever evolving, and fluctuates with the overall real estate market.
What is the capitalization rate, and what does it show you? Great question! We’ll cover everything you need to know, from the definition, to how to use it, and what it ultimately means for your real estate investment.
How Does Capitalization Rate Work?
To better understand the capitalization rate, let’s address some of the most commonly asked questions below.
What Is the Meaning of Capitalization Rate?
The capitalization rate is used to evaluate the rate of return across numerous real estate properties. As an investor, you want to fully understand your upside potential, or expected return, a property will provide you. That is exactly where the capitalization rate steps in.
Why is Capitalization Rate So Important?
The capitalization rate is so important because real estate comes in all shapes and sizes. Some properties cost $200,000, and other properties cost $20,000,000.
Without the capitalization rate, it would make comparing properties of different values increasingly more difficult. The capitalization rate levels the playing field, and treats the rate of return as an overall percentage.
How Is Capitalization Rate Used in Real Estate?
The capitalization rate is used to gauge the rate of return a given property has. Considering the rate of return is also closely tied to the overall risk profile of a property, the capitalization rate could also be treated as a proxy for the overall risk of a property. The higher the capitalization rate, the more risk the property may have.
How Is Capitalization Rate Calculated?
By now, you may be wondering what is the formula for the capitalization rate? Despite how important this metric is, the formula for calculating the capitalization rate is simple!
All you’d need to do is divide the net operating income, also known as the NOI, by the current market value of the property. For example, if you have net operating income of $5,000, and the property has a value of $100,000, your capitalization rate is 5%.
If you have a property that has net operating income of $30,000, and a property value of $1,000,000, you’d have a capitalization rate of 3%.
What Is a Good Capitalization Rate?
There is not a single number that defines a good capitalization rate. Good is defined on what you’re looking for, what your risk tolerance is, and what your goals are.
For example, if you want to generate a high rate of return, you’ll need to take on more risk. For the increase in risk exposure, you’ll want a higher capitalization rate.
If you’re looking for a safe real estate investment that provides consistent returns but won’t make you rich in the short term, a lower capitalization rate is what you should search for.
Factors Involved With the Capitalization Rate
There are numerous factors that are involved with capitalization rate. Here are a few to consider before diving into your calculations.
Net Operating Income
The net operating income, also known as NOI, is how much money a property generates after all operating expenses are paid. For example, if you are renting your property for $2,000 a month, and have $1,500 in expenses to rent such property, your NOI is $500/month.
Risk-Free Rate
The risk-free rate is the rate of return provided on a treasury bond. Treasury bonds are considered risk free because they are backed by the US government.
If the treasury bond pays a 3% interest rate over 10 years, as a real estate investor, you’ll want to surpass that interest rate on your rental property considering the extra risk that is involved with owning real estate.
Interpreting the Capitalization Rate
Once you’ve determined what the capitalization rate is, you need to compare that against other investment options. Similar to the above bullet point, are you comfortable making 5% owning real estate, knowing the work that goes into being a landlord, when you could make 5% investing in a dividend stock?
There is no right answer, its entirely up to the individual and their goals. But you need to take all options into consideration once you’ve calculated the capitalization rate.
One of the main variables to take into consideration with the capitalization rate is the fact that the capitalization is calculated using the current market value of the property, not the price you purchased the property for. For example, if you purchased the property for $500,000 in year 1, and the NOI was $50,000, your capitalization rate was 10%.
In year 10, that property may have appreciated to $1,000,000. If your NOI is now $60,000 a year, your capitalization rate is now 6%. If you are looking to make a 10% capitalization rate, you’d need to move onto another investment, or charge your existing tenants more money.
Advantages of Utilizing Capitalization Rate
- This metric allows you to compare different properties of different values in one standard way
- The capitalization rate is dynamic, and can adjust with market conditions
- The capitalization rate makes comparing the real estate investment to other investment options (including other real estate investments, the stock market, or the bond market) easy
Disadvantages of Utilizing Capitalization Rate
- The capitalization rate does not take into consideration leases that will expire. For example, if you are calculating the capitalization rate on a commercial property, and your main tenant is moving out next year, that could drastically throw off your capitalization rate
- The capitalization rate also assumes the asset is stable. Although one of the benefits is the capitalization rate adjusts over time, this is also one of the risks. Market conditions could swing the capitalization rate because the capitalization rate is calculated off of the market value of the property.
- Net operating income is a key number in the capitalization rate, but NOI typically looks in the rears and does not forecast future operating expenses. If the property’s operating expenses are increasing, calculating the net operating income on historical figures will be inaccurate, therefore, it would inflate your capitalization rate.
Capitalization Rate Vs. ROI
The biggest difference between the capitalization rate and the return on investment (ROI) is the fact that the return on investment is calculated by using the purchase price of the property. For example, if the property was purchased for $1,000,000 and has an annual return of $100,000, the ROI is 10%.
Whereas, if the property was purchased for $1,000,000, and is now worth $2,000,000 but the annual return stayed flat at $100,000, the capitalization rate would be 5%.
Statistics Make a Difference
The world of investing has a ton of statistics and ratios. Without question, if you’re not familiar with the definitions or formulas, it can be overwhelming and challenging to know which ones you should pay the most attention to.
If you want to get involved in investing, working with a financial advisor is a great first step. Financial advisors can not only help you make sense of all the ratios and calculations, they can also help you manage your risk and overall return.
Financial advisors are trained professionals who will not only be a good sounding board for you, they will also help you identify investments that make sense for you and your goals.
