What is a capitalization rate?

Dated: July 29 2020

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Commercial Real Estate Know-How

What is a capitalization rate?

A capitalization rate is the ratio of a commercial property's annual net operating income to its purchase price. It's typically shown as a percentage. Cap rate lets you evaluate a commercial real estate investment in varying asset classes, sizes, unit mixes, rentable square feet, or ages on the same terms.

So why isn't cap rate used in residential real estate? Because homes are valued based on similar nearby comparable properties that have recently sold. The value of commercial real estate is based on the income it produces, so cap rate is more common.

How to calculate capitalization rate

The cap rate calculation is pretty simple. To calculate a property's cap rate, you need the net operating income (NOI). This is the property's annual gross income minus annual expenses. The property's NOI doesn't include any debt, such as a mortgage or capital reserves, that may be held for the property.

To derive the cap rate, divide the NOI by the asking price or current market value of the property.

Cap Rate Formula

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If a property has a gross income of $400,000 and expenses of $150,000, the property's net operating income is $250,000. If the property is listed for sale at $3,000,000, the cap rate would be 8.3%.

Why is cap rate useful?

Cap rates let you compare commercial real estate properties independently of the purchase price. You can identify which would offer a higher return on investment regardless of the cost.

With a high cap rate, there is a higher potential return.

For example, an investment property may be listed for sale at $908,000 and advertise a 6% cap rate, while another can be listed for $1,200,000 and advertise a cap rate of 8%. The first property is expected to bring in $54,480 in income every year, while the second aims for $96,000.

Buyers can compare two investments based on their cap rate to help identify which investment is worth investigating further.

~ excerpted from an article by Liz Brumer on Fool.com

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Julie Hinojosa, CCIM

I'm an entrepreneur minded individual with real estate skills. Commercial and residential!....

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