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 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

Examples of Capitalization Rate Formula (With Excel Template)

Let’s take an example to understand the calculation of Capitalization Rate formula in a better manner.

You can download this Capitalization Rate Formula Excel Template here – Capitalization Rate Formula Excel Template

Capitalization Rate Formula – Example #1

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%

Capitalization Rate Formula – Example #2

Let us take an example of commercial property Ambience Mall in Delhi whose Net Operating Income is Rs 50 lakhs and 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

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

Capitalization Rate Formula – 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:

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%

Capitalization Rate for property B is calculated using 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%

Capitalization Rate for property C is calculated using 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 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

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 or not. 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 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 a 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.