Capitalization Rate Formula

Capitalization Rate Formula (Table of Contents)

• Capitalization Rate Formula
• Examples of Capitalization Rate Formula (With Excel Template)
• Capitalization Rate Formula Calculator

Capitalization Rate Formula

Capitalization Rate can be defined as the rate of return for an investor investing money in real estate properties based on the Net Operating Income that the property generates.

Let’s take an example of a commercial office property A where Net Operating Income for a year is $10000 and the Current Market Value of the property is $100000.

Solution:

Capitalization Rate is calculated using the below formula.

Capitalization Rate = Net Operating Income / Current Market Value of the property.

• Capitalization Rate = $10000 / $100000
• Capitalization Rate= 10%

Example #2

Let us take an example of the commercial property Ambience Mall in Delhi, whose Net Operating Income is Rs 50 lakhs and the current Market Value of the property is Rs 10 Crore.

Solution:

Capitalization Rate is calculated using the below formula

Capitalization Rate = Net Operating Income / Current Market Value of the property

• Capitalization Rate = Rs 50 lakhs / Rs 10 Crore
• Capitalization Rate = 5%

Example #3

Let us take an example where an investor has to decide in which property out of 3 properties he has to invest.

Solution:

The capitalization Rate for property A is calculated using the below formula.

Capitalization Rate for property A = Net Operating Income / Current Market Value of property

• Capitalization Rate for property A = $50000 / $1500000
• Capitalization Rate for property A = 3.33%

The capitalization Rate for property B is calculated using the below formula

Capitalization Rate for property B = Net Operating Income / Current Market Value of property

• Capitalization Rate for property B = $30000 / $750000
• Capitalization Rate for property B = 4%

The capitalization Rate for property C is calculated using the below formula

Capitalization Rate for property C = Net Operating Income / Current Market Value of property

• Capitalization Rate for property C = $20000 / $450000
• Capitalization Rate for property C = 4.44%

Since Capitalization Rate for property C is highest, hence the investor should invest in property C to gain maximum return out of the 3 properties that can be invested in.

Explanation of Capitalization Rate Formula

Capitalization Rate can be defined as the rate of return for an investor investing money in real estate properties based on the Net Operating Income that the property generates.

Capitalization Rate = Net Operating Income / Current Market Value of the property.

Net Operating Income can be defined as the total rental income generated by the property and then expenses are deducted from the income to arrive at Net Operating Income. The current market value of the property, as the name suggests, is the price in the current market that anyone would pay to buy the property.

Net Operating Income = Rental Income + Other Income – Vacancy and Collection Loss – Property Management Costs.

The capitalization rate shows the investor what would be his rate of return on the investment. Higher the capitalization rate, it is worth more for the investor to invest in. While the calculation of Net Operating Income, depreciation is not included since only operating expenses are deducted.

Relevance and Uses of Capitalization Rate Formula

The capitalization rate is useful for investors to compare properties. If all things are equal and any two properties have capitalization rates of 10% and 5%, then the investor should choose the 10% return offered by the property. It should be taken into consideration that the cap rate alone should not be a determinant in whether the property is worth investing in or not. A high capitalization rate means higher returns, but it also indicates higher risk. Hence investors should invest in properties based on their risk preferences.

For example, if there are two properties in which all factors are equal, except their geographic locations. One is located near the central part of the city, and the other is located in the suburbs. Hence, the first property located near the city center would garner more rental income. But this rental income would then be offset with costs like higher property taxes and the cost of maintenance. Since it is located near the city center, the current market value of the property will be higher than the property in the suburbs. Hence, the property in the city center will have a lower capitalization rate in comparison to the property in the suburbs. It indicates that a better valuation is realized with a lower capitalization rate. This indicates property with a lower capitalization rate yields better returns with a lower level of risk. But the real-world scenarios are not that simple. One cannot look only at the capitalization rate as the decisive factor in choosing a property.

Capitalization Rate Formula Calculator

You can use the following Capitalization Rate Calculator.

Conclusion

Capitalization rate can be defined as the rate of return sought by an investor while investing in real estate properties. Calculation of Capitalization rate is done by dividing Net Operating Income by Current Market Value of the property. Net Operating Income is calculated by subtracting operating expenses from the rental income generated from the property. The operating expenses do not include depreciation. Capitalization rate should not be a single factor in estimating whether a property is worth investing in.

Recommended Articles

This has been a guide to Capitalization Rate formula. Here we discuss How to Calculate Capitalization Rate along with practical examples. We also provide a Capitalization Rate Calculator with downloadable excel template. You may also look at the following articles to learn more –

1. Formula for Capital Asset Pricing Model
2. Cost of Goods Sold Formula
3. How to Calculate Diluted EPS?
4. Average Collection Period Formula
5. How to Calculate Capitalization Ratio?