Capitalization Rate

What it is:

In real estate, a capitalization rate is a measure of return on investment. The formula for capitalization rate is:

Capitalization Rate = (Expected Income from Property – Fixed CostsVariable Costs)/Property Value

How it works (Example):

Let's say Jane Doe buys a house to rent out for extra income. The house costs \$100,000. She borrows a 30-year mortgage at 5% to pay for it, meaning her payments are \$536 per month, her property taxes work out to \$165 a month, and the insurance on the place runs \$60 a month, for a total outlay of \$761. She rents the house out for \$1,000 a month.

Using this information and the formula above, we can calculate that Jane's capitalization rate for this property is:

Capitalization Rate = ((\$1,000 - \$761) * 12 months)/\$100,000 = 2.868%

It is important to note that capital improvements such as a new roof or carpeting are not included in the cap rate calculation. Only operating expenses are included.

Why it Matters:

Capitalization rates allow real estate investors to place values on income-producing properties. The formula is also a way to estimate what similar income-producing properties should sell for.

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