What it is:
How it works/Example:
Let's say Jane Doe buys a house to rent out for extra mortgage at 5% to pay for it, meaning her payments are $536 per month, her property 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 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 allowinvestors to place values on income-producing properties. The formula is also a way to estimate what similar income-producing properties should sell for.