The capitalization rate is a term used in commercial Real Estate to refer to the rate of return expected to be generated from the real estate investment property. It is also called the Cap rate. This method is used to understand how much an investor can expect to gain as a return on their investment in the real estate Market.
It is important to note that there is no good or bad cap rate. The rate depends on the context of the property on the market. However, they are useful for comparison of relative values when it comes to similar real estate investment. This method is used to assess the profitability when it comes to real estate. Basically, the capitalization rate is nothing but the return an investor will get for a property over a period of one year when purchased with cash and not a loan. It refers to the natural rate of return in the market.
One of the most popular formulas for capitalization rate is to divide the property’s net operating incomes by the current market value.
Capitalization Rate= Net Operating Income/ Current Market Value
Net Operating Income: This is the annual income that comes from a property in place. This is what an investor gets after the Deduction of expenses incurred from the management of the property.
Current Market Value: This is the value of the property based on the present-day market rates.
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Jayesh has Rs. 50 lakhs to buy a property. He looks at three properties and looks at three aspects of the property i.e. market value, annual income and expenses. Based on these three aspects, he will make a decision to purchase the property. Whichever has the least expenses and the high profitability will be his definite choice.
Property 1: The market value is Rs. 40 lakhs
Property 2: Market Value= Rs. 60 lakhs
Property 3: Market Value= Rs. 40 lakhs
After making careful calculations, Jayesh chooses to purchase property 3 because it has the highest cap rate. The profitability is high and expenses are low.