What is the capitalization rate?
Capitalization rate is the estimated percentage rate of return that a property will produce on the owner’s investment.
Capitalization rate can be determined by dividing the annual net operating income by the cost of a piece of property. This formula is important to determine the percentage of return on an investment that an investor can hope to recognize.
As a capitalization rate goes up, the valuation multiple of the asset goes down. The determination is inversely correlated to the price/earnings multiple that is figured for the same asset.
Capitalization rate is often calculated by using the current market price on the property over a specific period. When the market price is stable, the rate does not change. However, as prices rise or fall, the rate can change.
Since market prices are out of property owners’ control, the only variable that the owner exercises some control over is the net operating income (NOI). Thus, the owner must find a way to increase the NOI to correspond with the rising market price.
As you might expect, a higher capitalization rate is more favorable than a lower one. This means that as market values shift, business owners need to stay on top of their income from the asset they’ve invested in to get favorable rates.
Capitalization rate example
If you purchase a piece of property for $100,000 and anticipate that your annual income from that property will be $15,000, then your capitalization rate would be 15,000/100,000, or 15 percent.
Let’s say that the property values in your area rise by 10 percent, and the next year, your property is valued at $110,000. Thus, your capitalization rate for the second year would be 15,000/110,000, or 13.6 percent.
At this point, your capitalization rate has fallen. If you anticipate that market values will continue to rise in your area, you will need to consider increasing your NOI by bringing in more revenue or cutting more expenses to bring your capitalization rate back up.
Curious to learn more about the loan rates for property investments? Check out more information on current mortgage rates.