What is a Capitalization Rate? Explained by a Southwest Michigan Property Manager

The capitalization rate, which most investors refer to as the cap rate, is the ratio of your net operating income to your property’s value. Understanding your cap rate can help you evaluate how your property is performing and also tell you whether a particular investment is a wise one to make.

Calculating Cap Rate

You can get a better idea of what a cap rate means to your investment if you think about a specific example. Here’s one. Let’s say you want to buy an apartment building with a net operating income of $600,000. The building costs $10 million. If you close the deal, you’re getting a cap rate of six percent because you divided the $600,000 operating income by the $10 million price tag. That’s a cap rate that most investors would be comfortable with. If you talk to people who buy and sell property, you’ll learn that depending on their unique situations and the markets they’re in, a cap rate of between four percent and 10 percent is fairly standard.

How to Use a Cap Rate

When you’re selling your investment property, you want a lower cap rate. This indicates a higher property value that will earn you more in the sale. If you’re buying an investment property, you’re probably looking for a cap rate. You’ll have a lower amount to invest initially. Whether you’re buying or selling a piece of real estate, you’ll want to look at the cap rates for similar properties in your location. Look at recent sales in your immediate market, and make sure the property is similar to yours. An office building is not going to measure well against a 6-unit apartment building.

Look at cap rates when you are thinking about acquisitions or looking for trends in a particular market. It’s an easy calculation, and historical data can help you make good investment decisions.

Rental Income and Cap Rate

Before you can establish and evaluate a cap rate, you have to understand what kind of rental income can be expected on a particular property. That number is going to contribute heavily to the net operating income. If there’s not already tenants in place to give you the figures you need, you’ll have to conduct an analysis of the market. Work with a professional Southwest Michigan property manager who knows the market, the properties, and the tenant pool in your area. You’ll want to know what a property like yours rents for, how long it stays on the market before it’s occupied, and what sorts of tenants will be interested in the home. All sorts of variables will affect the net operating income, including the average length of a tenancy, projected rental increases, and even things like eviction and vacancy rates.

The more data you have, the better you can establish a reliable cap rate before purchasing an investment property.

We work with these numbers all the time. If you’d like help establishing a cap rate on a property you currently own or one you’re thinking of buying, contact us at Real Property Management Southwest Michigan. We’d be happy to help.