Real estate investment is one of the reliable ways to make money. However, it requires a skilled expert investor to succeed in the business and achieve the desired investment goals. This expertise comes either from acquiring the skills or having a trusty investment property calculator that masters those skills. In this article, one of the fundamental and supposedly well-known terms in real estate will be addressed. Of course, the majority of real estate investors have heard of the capitalization rate term or thought they fully recognize it, but here we will be showing you that capitalization rate isn’t merely a number; it’s much more!
Capitalization rate, or cap rate, for short, is a widely-used calculation that informs the real estate investors about the expected probability form their investment properties. Capitalization rate is a metric that calculates the potential return of the real estate property derived from its net operating income. It can be calculated by dividing the net operating income by the property value in the current market. The formula in simple is:
Capitalization rate = (Net operating income/Property value in the current market) x 100
For example: If a real estate investor purchased a rental property for $100,000, and it’s expected that it will generate $15,000 each year in rental income, then the capitalization rate will be ($15,000/$100,000) x 100= 15%. This means that the real estate investor will earn 15% of the total property costs each year. This rate will give the investor an initial idea about the expected performance of the rental property. It can be used to compare several investment properties in the same location.
But it’s worth mentioning that the capitalization rate deals with the current value of the investment property in the market which may be misleading sometimes since the real estate market rarely stays constant. And the market value of any property may be changed dramatically in a short period of time. If the market value of the real estate property climes up, while the investor gains the same amount of money form it, then he/she will get a lower capitalization rate. On the other hand, if the market value decreases, while the investor gains the same amount of money, then the capitalization rate will increase.
A related point to consider is that calculating net operating income (NOI) isn’t an easy task. It is calculated by subtracting ALL the operating costs including taxes, maintenance, legal expenses, insurance, and other costs from the rental income of the property. Any left factor can cause highly misleading figures.
Is cap rate analysis as easy as it seems?
Not really. In addition to the previously mentioned factors, real estate investors need to have a futuristic perception of where the capitalization rate is heading. No expert real estate investor wants to have a bright number for just a couple of years. Consequently, there is a huge necessity for precise predictions of the housing market and the risks of the real estate investing deal.
Why does capitalization rate matter?
Simple answer. It gives the real estate investor the green light to start further analysis regarding the investment. First, the cap rate allows a real estate investor to compare the intended investment properties with other similar properties (e.g. location, costs, expenses, etc.) that have similar features to decide which one to consider and analyze. If a certain real estate investment property has a higher capitalization rate than a similar property, then it has more potential to succeed in making money in real estate. Second, cap rate helps investors to form trends of which investments are growing and which ones are shrinking. If, for instance, the cap rates of several properties in a certain neighborhood are climbing up in comparison with historical figures, then it’s an indication that investing in this area is worth considering. In addition, it guides real estate investors about the pricing process of rental properties. Third, the capitalization rate is so helpful when the real estate investors don’t have enough data about recently sold properties that are similar in the characteristics to the intended real estate investing process.
Related: Why Is the Cap Rate Used in Real Estate? How Do You Calculate It?
Is cap rate the same as return on investment?
Whether the capitalization rate is representing the real return on investment or not is related to the source of the money that was used to finance the property costs. If, for instance, the real estate investor uses only cash to finance the property, then the return on investment will be accurate in a sense. Anyway, it’s not uncommon that investors use debts or loans to finance their real estate investments. In such cases, there is a need for other calculations that give accurate figures of the return on investment like cash on cash return. Cash on cash return gives the real estate investor the ratio of the annual cash flow of the investment before taxes to the amount of the invested cash. If the rental property cash flow isn’t constant and changes dramatically, it’s not recommended to rely on capitalization rate. It’s advisable to use alternative analysis like discounted cash flow valuation.
Related: Real Estate Investing for Beginners: How to Measure Return on Investment
Confused which method of calculation gives more insightful knowledge regarding your real estate property? You’re right to feel so. There is no real estate calculation that can give the right guidance in isolation. Hence comes the real need for more comprehensive investment property analysis that proves which way is the best for making money in real estate. There are plenty of investment property calculators that can be used by investors to take more thoughtful economic decisions. Tried Mashvisor? If not, you should.
To conclude
Capitalization rate sounds like an easy and straight forward calculation. But it’s never as easy as it seems in the real estate investing world. Real estate investors should always have on mind that no matter how accurate the calculation is, it’s never accurate enough to rely on alone. Real estate investing should rely in comprehensive and precise analysis that can’t be achieved by a sole formula. It needs huge amount of research and calculation that analysis tools can offer. Mashvisor offers an investment property calculator that can save your time and energy and help you in making money in real estate. So, start out your trial with Mashvisor today.