What is the Capitalization Rate?

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 Does the Capitalization Rate Work?

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 Does the Capitalization Rate Matter?

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.