Real Estate

Real estate capitalization rates

Capitalization rates (or capitalization rates, as they are more commonly called) are one of the most popular returns associated with real estate investing.

As such, it is not uncommon for a capitalization rate to appear in a real estate analysis within reports such as an APOD or a proforma income statement.

Those of you who have been committed to rental income property for some time certainly know this already. So for you, compounding rates are not a mystery.

On the other hand, beginning real estate agents and investors with less experience in rental income properties would naturally have questions and want to know more to make proper use of this popular yield.

So I found it necessary to present an overview.

Meaning

The compounding rate is the rate at which future income is discounted to determine its present value.

But this is the technical definition and it will really mean little to you in the real world, so let me generalize what it does mean in practice: a capitalization rate expresses the relationship between the value of a property and its net operating income.

Net Operating Income / Property Value = Capitalization Rate

In other words, it shows what percentage of a property’s value (or sale price) is attributable to its income stream.

This is important to investors because net operating income is the amount of cash flow available to make mortgage payments. And in cases where the investor makes a cash purchase without a mortgage payment, the capitalization rate is pretty much the investor’s rate of return on that income stream.

Therefore, it stands to reason that investors want to base their investment decision on the highest possible capitalization rate.

Remember, higher capitalization rates mean more price-related net operating income and therefore imply a higher rate of return produced for the investor on the investment, and vice versa.

Request

Capitalization rates are commonly used by investors, agents, and real estate analysts for various informational reasons.

  1. Evaluate and compare the financial performance of various real estate investment properties. This is useful when multiple rental properties are being considered.
  2. Determine if the sales price of an income property is in line with the price of recently sold comparable income properties. This helps avoid paying more than market value.
  3. Establish a sales price for an investment property that is about to be listed for sale based on local market values.

Nuances

There is no “ideal” or “standard” capitalization rate. Real estate capitalization rates are driven by the market.

  1. Above all, they are based on the real estate investor’s personal investment objective, which, of course, is highly arbitrary and varies from buyer to buyer.
  2. Second, they are based on the property’s location, rent stability, condition, neighborhood risk, and potential for appreciation. You wouldn’t expect a relatively new property located in a well-kept neighborhood near a city’s growth corridor to have the same value to a buyer, for example, as an older property in need of repair located in a deteriorating part of town.
  3. Third, they are based on the geographic location of the real estate market. An apartment complex located in Orange County, California, for example, would likely admit higher values ​​marked by lower capitalization rates than a complex located in Detroit, Michigan.

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