Real Estate Investing Terms: Capitalization Rate

Cap Rate...it's not science rockets!? Wait, did I say that wrong?

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Capitalization Rate (Cap Rate for short) is the measurement used to reveal how well a real estate investment will perform or is performing. I look at 3-5 investments in Pensacola a day and Cap Rate is one of the factors I consider when investing or deciding to hold onto or let a property go. There are many ways to calculate Cap Rate but I do it by dividing the annual net operating income by the original capital costs (or its current market value). I explain why the potential to use different denominators below.

The example we'll use for this post is a SFR with a purchase price of $50,000 and after all monthly expenses are paid, I expect $350/month in positive net cash flow (or $4,200/yr.), So, the net operating income for this property is $4,200/yr. Cap Rate is calculated as follows:

• $4,200 / $50,000 = 8.4% Cap Rate

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A couple of resources we use, put Pensacola property appreciation between 1.2-1.8% annually, on average, for the last 30 years. For this calculation we'll land in the middle using 1.5% appreciation.

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Using our same example, let's fast forward 10 years down the road. Now that I've owned the property for ten years, I want to see how this piece of property is performing against other properties in my portfolio. To recap, I purchased the property, made some improvements and some natural appreciation has occurred. Forcing appreciation by improving the property has allowed me to increase rents over the last 10 years. By doing so, this property's annual net operating income is now $6,000 and with 1.5% appreciation for the last 10 years, the property is now worth approx. $58,000. After owning the property for 10 years, my Cap Rate calculates as follows:

• $6,000 / $58,000 = 10.34% Cap Rate

At the 10 year mark, if I use my original purchase costs to calculate Cap Rate, my cap rate would look like this:

• $6,000 / $50,000 = 12% Cap Rate (higher, but not an accurate insight on how this asset is performing today)

Cap Rates are used to compare one investment to another. If I've owned the Pensacola property for years, I use the present market value as my denominator. If I'm underwriting a property for potential purchase, then my denominator is my expected initial costs.

Thanks for reading!