How to calculate the capitalization rate
Real estate investors rely on different types of information in negotiations for income-producing properties, for example, the appropriateness of the location of the property and / or any future changes in the neighborhood are the two most common factors. Crucial information that helps investors make their decision is called the capitalization rate. The capitalization rate (expressed as “the ratio of net property income to its purchase price”) allows investors to buy property by evaluating the rate of return on the investment made in the property. See step 1 to calculate the capitalization rate of your home!
Calculate the gross annual income of real estate investments. The gross income of an investment property will be mainly for rentals. In other words, when a real estate investor buys a house, he / she usually makes money mainly by renting it to tenants. However, this is not the only possible source of income, various income can be accumulated in the property in the form of dispensing machines or washing machines, etc.
- For example, let’s say we just bought a house that we plan to rent to tenants in the amount of $ 750 per month. With this rate, we can expect to earn those 750 for 12 times = $ 9,000 per year in gross income for the property.
Subtract the operating expenses associated with the gross income property. A part of real estate comes with operating costs. Usually, these are for maintenance, insurance, taxes and property management. Use accurate approximations for these numbers and borrow them from the gross income you found earlier. This will give you the “net income” of the property.
- For example, let’s say, after having our rental property valued, we can expect to pay $ 900 for property administration, $ 450 for maintenance, $ 750 for taxes, and $ 650 for insurance per year for our property. 9,000 – 900 – 450 – 710 – 650 = $ 6,290 , the “net income” of our property.
- Note that the “NO” capitalization rate is considered for the business expenses of the property, including the cost of buying the property, mortgage payments, charges, etc. Because these elements reflect the investor’s position with the lender have a variable nature, they negatively affect the neutral comparison that the capitalization rate must give.
Divide the net income by the purchase price of the property. The capitalization rate is the ratio between the net income of the property and its original purchase price or cost of capital. The capitalization rate is expressed as a percentage.
Let’s assume we bought the property for 40,000. Given this information, we now have what we need to calculate our capitalization rate. See below:
- $ 9000 (gross income)
- $ 900 (property administration)
- $ 450 (maintenance)
- $ 710 (taxes)
- $ 650 (insurance)
- = $ 6290 (net income) / $ 40000 (purchase price) = 0.157 = 7% capitalization rate
Use the capitalization rate to quickly compare two similar investment opportunities. The capitalization rate basically represents the approximate percentage of return that an investor can obtain in a completely cash purchase of the property. Because of this, the capitalization rate is a good statistic to use when comparing potential acquisitions with other investment opportunities of a similar nature. Capitalization rates allow for quick and difficult comparisons of earning potential when investing in properties and can help you narrow your list of options.
- For example, let’s say we are thinking of buying two properties in the same neighborhood. One has a capitalization rate of 8% while the other has a capitalization rate of 13%. This initial comparison favors the second property, it is expected to earn more money for every dollar you invest in it.
Do not use the capitalization rate as the only factor in determining whether the investment will be good or not. While the capitalization rate offers the opportunity to make simple, quick comparisons between two or more properties, it is “far” from being the only factor you should consider. Real estate investments can be very difficult, seemingly similar investments can be subject to market forces and unforeseen events that go beyond the point of view of a simple calculation of the capitalization rate. Finally, you will also want to consider the potential growth of income for your property as some change in the value of the property itself.
- For example, let’s say we bought a property for $ 1,000,000 and we expect to earn $ 100,000 a year for it, this gives us a capitalization rate of 10%. If the local housing market changes and the value of the property increases to $ 1,500,000, suddenly, we have a less profitable capitalization rate of 6.66%. In this case, it may be good to sell the property and use the profit to make another investment.
Use the capitalization rate to justify the level of income of the property. If you know the capitalization rate of the properties in the area of the property in which you invested, you can use this information to determine how much net income you will need to obtain to make the investment “worthwhile”. To do so, simply multiply the price that is being asked for the property by the capitalization rate of similar properties in the area to find your “recommended” net income level. Take into account that this is done by solving the equation (Net / Initial Income) = capital rate for “net income”.
- For example, if we buy a property for $ 400,000 in an area where most similar properties have a capital rate of 8%, we may find that our “recommended” income level by multiplying 400,000 by 08 = $ 32,000. This represents the amount of net income that the property must generate per year to have a capitalization rate of 8%, to determine the rental rates according to this.