It is basically a return on investment (ROI) for a property. The concept of capitalization rate gains its existence from the real estate business. The capitalization rate calculator calculates the yield on the investment in property in a particular period.
It assumes that the property is bought for cash only and no borrowings are made for such purpose and which makes it a bit impractical. And hence, it has an unleveraged effect on its calculation.
There is no ideal capitalization rate for evaluating profitability. However, the higher rate is better as it would help in recovering the cost faster.
The formula for calculating the capitalization rate is:
Capitalization Rate = Net Operating Income/Market Value of Asset
Here, net operating income includes only the income generated from such assets under the investment. It can be calculated by deducting operating expenses from gross income. The capitalization rate is expressed in percentage terms.
About the Calculator
Following are the details to be entered into the capitalization rate calculator for a quick result.
Market Value of Asset
We consider the market value of assets prevailing in the market at the time of calculation instead of book value. However, one may take book value into account. But this book value may not be a feasible base for calculation if the asset’s ownership is by way of inheritance and not by purchase. Also, the value of assets in the real estate market keeps fluctuating. Therefore if the assets are purchased recently or there is no major difference between the purchase price and market price, we may go ahead with book value. Otherwise, we should take the current market price of the property to take a realistic view of the capitalization rate and available opportunities.
Enter the amount of gross income. The income on the investment before paying any expenses is its gross income. Gross income means the total potential income, the asset is able to generate less any loss due to vacancy or non-clearance of payment.
Operating expenses include costs we incur to operate and maintain properties in order to earn income from them. It includes property taxes, maintenance fees, insurance premiums, etc. But, this does not take any financial charges into account (due to the assumption of no loan taken). Depreciation also does not form a part of it.
Assume that the gross income from a property is $80,000 (assuming 100% occupancy) and the operating expenses are $20,000. The market value of the property is $750,000.
Therefore, net operating income = $60,000 (i.e. $80,000 – $20,000)
Capitalization Rate = (60,000/750,000)*100 = 8%
Now, let us review these rates when the basic assumption with regard to various key factors varies. This will give us more clarity with regard to the likely changes and impact of each and every factor and its importance while making the return expectation.
- Scenario I: There is 15% vacancy, i.e. the property occupancy is only 85% instead of 100%
Now, the net operating income will be $48,000 (80,000 – 15% of 80,000 – 20,000).
And, capitalization rate will be 6.4% (48,000/750,000)
- Scenario II: Market value of the property decreases to $600,000
Net operating income: $60,000
Capitalization Rate: 10% (60,000/600,000)
- Scenario III: Market value of the property increases to $800,000
Net operating income will be same, that is, $60,000
Capitalization Rate: 7.5% (60,000/800,000)
- Scenario IV: Operating expenses increased by $25,000
Net operating income: $35,000 (80,000 – 20,000 – 25,000)
Capitalization Rate: 4.67% (35,000/750,000)
All these cases determine the risk in the real estate business. Variation in any one factor can make significant changes in the capitalization rate, which the investor aims to get.