Investing in real estate can be a tricky prospect, so it makes sense to try to determine how profitable a given property is likely to be. That's where the capitalization rate comes into play. The capitalization rate, or cap rate, measures the return on investment for a real estate investor. It is calculated by dividing the property's net operating income, or NOI, by its current market value.
Calculating capitalization rate
In order to figure out a property's capitalization rate, we must first calculate its net operating income, which is the property's revenue minus its operating expenses. If a property generates $300,000 in revenue over a year but costs $200,000 to operate, its annual NOI is $100,000.
Once we establish NOI, we can divide it by a property's current market value to arrive at a capitalization rate. Let's say a property whose NOI is $100,000 per year is on the market for $800,000. In that case, the property's capitalization rate would be 12.5% ($100,000/$800,000 = 0.125, or 12.5%). What this means is that if someone were to buy that property, that investor would stand to earn 12.5% of the property's value as profit each year, assuming that NOI and market value remain constant.
Uses of capitalization rate
The capitalization rate is a great way for investors to compare different real estate investments. If there are two buildings on the market at completely different prices, it can be difficult to determine which constitutes the better investment. A building that costs $500,000 is not necessarily a better investment than one that costs $600,000 just because its purchase price is lower. Rather, it's important to understand how much of a return on investment each building is likely to produce, and comparing two capitalization rates can help an investor make this determination.
The capitalization rate can also be a good starting point for investors looking to break into the world of real estate. An investor, for example, might insist on only buying property with a capitalization rate of 10% or higher; otherwise it might make more sense for that investor to put money into stocks or another vehicle instead.
The capitalization rate is also a useful tool for evaluating a property's profitability over time. If a property's net operating income rises while its market value remains the same, its capitalization rate will rise. For an investment property to remain profitable as time goes by, its net operating income must increase either at the same rate as its market value, or at a greater rate. The capitalization rate is a strong measure of whether a property is becoming more or less profitable.
Limitations of capitalization rate
While the capitalization rate is a very useful tool for real estate investors, it also has its limitations. Because the formula is based on a property's net operating income, arriving at an accurate figure can be difficult if a building is fairly new and its revenues and operating expenses have yet to be established. In other words, the capitalization rate can be a helpful measure for a building that's been renting out apartments for five years, but it would be less so for a new building whose apartments are still half-vacant. That's why the capitalization rate is only one calculation to look at when deciding whether to pursue a real estate investment.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org . Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.