Real estate investing is a very profitable and financially rewarding business, so long as investors study the prospects of their investments and estimate the rate of return on their properties and income potential before closing the deal. Amongst the many real estate terms and lingo you should familiarize yourself with as an investor, capitalization rate should be at the top of your list. Why, you might ask? To give you a straightforward answer: Key performance metrics quantify and estimate a real estate investment’s profitability and earning potential. Conducting the right due diligence and real estate market analysis is necessary to decipher the good investments from the bad. Nowadays, real estate investors can instantly identify positive cash flow properties with high cap rate and cash on cash return via Mashvisor’s investment property calculator and cap rate calculator. These are just few of the tools Mashvisor offers to guarantee profitable investments with high return on investment.
Related: How to Calculate Return on Investment in Real Estate: 5 Different Ways
What Is Capitalization Rate?
To put it in simple terms, capitalization rate is synonymous with the rate of return on a real estate investment. The return on investment is the real estate investor’s estimated earning potential. Cap rate is a good metric to estimate the profitability of any real estate investment. Of course, it goes without saying, the higher the capitalization rate, the better.
To calculate the capitalization rate of a real estate investment, take the net operating income (NOI) and divide it by the current market value/price of the property. The NOI is simply the annual net return on the investment property after discounting all of the operating costs.
Capitalization Rate = (Net Operating Income/Current Market Value) x 100%
NB: The capitalization rate is always expressed as a percentage.
With Mashvisor, there is no real need to calculate the rate of return on your real estate investment manually because the capitalization rate is readily available for real estate properties across the country. Whether they decide to invest in traditional real estate or short term rentals, real estate investors can differentiate and compare real estate properties based on their cap rate and cash and cash return.
Keep in mind, cap rate is relative and must be compared to other similar real estate properties to identify which investment is best in terms of rental income and returns in the long run.
Related: How Do You Conduct Residential Property Market Analysis?
Mathematical Formula
Cap Rate (%) = (Net Operating Income/Current Market Value) x 100
Net Operating Income (NOI) = Annual Rental Income – Operating Expenses
Current Real Estate Market Value (MV) = Price of the Property
Quick Example
Property A has a NOI of $140,000, and its current MV reaches a lump sum of $1,500,000. Meanwhile, property B has a NOI of $130,000, selling at $1,000,000.
If NOI remains the same, which one is a better investment for the real estate investor?
Cap Rate Property A = (140,000/1,500,000) x 100 = 9.33 %
Cap Rate Property B = (130,000/1,000,000) x 100 = 13%
To reiterate, the higher the cap rate of an investment property, the more profitable the investment. The cap rate is inversely related to the current market value, but is in positive correlation with the net operating income. This means that the higher the price of a real estate property, the lower the cap rate, and vise versa. It is also directly related to the NOI, which depends on the rental income: the higher the rental income and the lower the running expenses, the higher the cap rate, and vice versa.
So, the general rule of thumb for real estate investors is to be on the lookout for buying rental properties at a relatively lower market value, but higher net income, after taking into account the operating costs and expenses, to reap a high cap rate. In the example above, property B is definitely the smarter real estate investment decision, based on the cap rate, all else kept equal.
What Is a Good Benchmark for Capitalization Rate?
Capitalization rate is relative and should be assessed and compared with other cap rates in order to find the best real estate investment for growing your returns. While a cap rate of 10% can be excellent for a certain location, it might be pretty low for another location. Calculating the cap rate, as part of the process of investment property analysis, is an easy and quick way to compare many investment opportunities with one another. Head over to Mashvisor to find your next investment property based on real estate comparables, aka comps. Moreover, with Mashvisor’s analytical tool, real estate investors gain quick access to other key metrics to evaluate the rental property in question: from expected rental yield, through Airbnb occupancy rates, to cash-on-cash return (CoC) for single famly properties, neighborhoods, and city averages.
Maximize Your Rental Income With Location
A good location maximizes the rental income and in turn drives the cap rate up. Location, location, location becomes the real estate investor’s competitive advantage to maximize his/her cash flow returns and grow his/her real estate investing business. Right now, the best places to invest in the country reap higher cap rates because of high rental demand. The law of economics, ladies and gents: The higher the demand, the higher the return on investment, all else equal. Long story short, invest in thriving real estate markets and good neighborhoods to reap high returns over the long run.
Related: Investment Property Calculator For Analyzing Real Estate Investments
Conclusion
If you acquire the right education, conduct real estate market and investment property analysis, and have access to the best real estate investing tools, you are in a much better place to take calculated risks for seeking higher returns on your real estate equity. The cap rate is a good metric to use for finding investment properties, however, it does not operate solely. Make sure you use other real estate metrics to assess the overall value of a real estate investment in the long term. Capitalization rate is not set in stone and is bound to change, given the dynamic nature of the real estate market.
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