Definition: The capitalization rate (cap rate) indicates the potential rate of return on a real estate investment, taking into account the income that the property is likely to generate by comparing the property value and it’s NOI.
What Does Capitalization Rate Mean?
What is the definition of capitalization rate? The cap rate is one of the most important concepts in real estate investing as it provides an indication of the rate of return based on the net operating income of a property and its current market value. The net operating income is the income that remains after deducting property taxes, maintenance costs, and other operating expenses from the gross operating income, except for depreciation expenses.
To calculate the capitalization rate formula of a real estate investment, we need to know the current market value and the net operating income of the property. The higher the cap rate is, the higher the return on investment.
Let’s look at an example.
Example
George buys a new house for $350,000. Based on what his realtor told him, the property is expected to generate about $85,000 annually. Hence, the cap rate for George’s property will be:
Cap rate = Net operating income / Current market value = $85,000 / $350,000 = 24.3%
In simple terms, this means that George will earn 24.3% annually from his property.
However, when calculating the cap rate, we need to consider that the real market is often fluctuating. For instance, assume that George buys his house in a period that the real estate market is relatively steady. Yet, after a couple of years, there is a slowdown in the market as a result of uncertainty and low interest rates. When does this leave George? With a property that he bought for $350,000 and after two years it sells for $100,000.
In the meantime, George has earned 24.3% in the first year, and 8.3% in the second year because the sales price of the property dropped to $300,000 and the property generated $25,000. On the other hand, if George buys his house when the real estate market is flourishing, after two years, the sales price of his property may be $500,000, and it may generate $180,000. So, the cap rate will be 36.0 percent.
Summary Definition
Define Capitalization Rate: Cap rate means a financial ratio that compares a property’s value with its net operating income.
