Capitalization Rate

August 22, 2024

The Rate of Return on Your Investment

If you are thinking about purchasing an investment property consider the annual rate of return on your investment before furthering your negotiations. Compare the net operating income to the estimated market value to determine the capitalization rate.

To establish the market value, it is important to analyze similar properties in the specific area of interest through a comparative market analysis. Seeking assistance from a licensed Real Estate Consultant can aid in this process, as they will search for comparable properties in the same market that share similar characteristics and age.

With the expenses, it is important to receive the expense history for the property you are considering purchasing for investment. Expenses may include property tax, or municipal, condo or HOA assessments fees, insurance, and the age can be a factor to consider because the roof, water heater, window or doors may need repair. Cleaning fees (short term rentals), managing fees, vacancy, utilities (that the owner would pay), and maintenance costs are all common expenses to consider when figuring the net operating income (NOI). The total annual revenue of a property minus the operating expenses is the NOI.

By calculating the ratio of Net Operating Income (NOI) to the market value, you can establish the capitalization rate of an investment property, which aids in assessing the property's cash flow over a year. Analyze whether the property exhibits a higher or lower cap rate. The cap rate is subject to variation based on the investor and investment type, typically indicating that a higher cap rate corresponds to increased risk in the investment.

A cap rate determines the annual cash flow for the investment property or the annual rate of return on the money invested in the property. Typically a 5% -10% rate of return is the threshold. Dividing the properties NOI by the current market value determines the capitalization rate.