Capitalization rate which is also known as Cap rate is an important aspect for Real estate investors. Capitalization rate gives you the idea of the market value of a property you wish to invest in. Cap rate is actually the rate of return you get on investing a real estate property based on its current market value. That gives you a financial analysis and a comparative figure on different property options which can be a residential or office building.
Let’s say if you are wishing to invest in a property worth INR 25,00000 expecting that it would give you INR 500,000 per year after all the operating costs would define its capitalization rate to be 20% (500000 / 2500000 = 0.20 = 20%). That sums up your investing factor which is largely based on cap rate for safe investments. Let’s say a property worth INR 500000 gives you 13% capitalization rate while another one worth INR 1000000 gives you 10% cap rate, you will obviously turn towards the first one keeping in mind the investment benefits.
So, you can clearly see that comparing cap rate before investing in real estate may come beneficial for you. In terms of investing in commercial property, a cap rate is a powerful tool for real estate investors. Also, investors should keep in mind the operating factors that vary largely when it comes to commercial properties as that cost plays a crucial role in cap or capitalization rate.
But not every investment should completely rely on cap rate alone. For example: if a property worth INR 1000000 gives you a cap rate of 10% but as its market value increases, its cap rate will gradually decrease. Here you can see, not just the capitalization rate but there are several other factors too that decides the future of your investments. So one should not blindly follow capitalization rate when it comes to real estate investments on which brokers often try to entice you to make up the deal.
Formula For Calculating Cap Rate:
As per proper definition, the Capitalisation rate is nothing but Net Operating Income (NOI) divided by the price at which the property has been purchased and it delivers nothing but the annual return on your real estate investment of a specific property. Mathematically, the formula can be derived as:
NOI (Net Operating Income) / Market Value Of The Property = Capitalization Rate (Cap Rate)
Remember, that the market price should increase gradually with the NOI. If any of these factors will increase or decrease significantly it will impact the overall cap rate hence making it a variable factor. To keep Cap rates constant both these units must not vary largely over the time.
Factors Responsible For Right Capitalization Rate
While looking up for a potential investment property there are several factors that may decide the right cap rate including asset type, location, market value. Let’s discuss them one by one to obtain better clarity.
Location:
Following the old adage of real estate society, “Location Is Everything” capitalization rate plays negligible significance here in deals made. You may ask why? And the reason is simple: “Lower Risk”. Lower risk in buying property in a metropolitan area or reduces the risk factor even when the capitalization rate is found to be much lower than a location lies in the suburbs.
Interest Rates:
Even when you have no control over interest rates you should stay aware of where it is headed. If interest rates are on a hike the cash flow in the property will gradually decrease making the void deeper if you’re just considering cap rates. With the increase in interest rates, debt rates will increase hence hindering the cash flow. This is definitely going to lower down the cap rate for a certain period.
Assets:
If you’re willing to invest in real estate, you can opt for any type of property whether it is an office building or a hotel. But when it comes to risk-free investing there’s nothing better than multifamily apartments.
The reason is simple,
One, even if it is recession people needs a place to live. Even when the whole economy goes up and down the desire for a home to stay is not going anywhere depending on worlds or local economic factors.
Secondly, if you’re building an office space it is difficult to find a new tenant in case the whole office relocates, especially in the time of recession whereas in an apartment building, if one tenant relocates it is not going to affect the overall gross profit percentage on a larger scale making it a win-win situation for the investor.
Summing up these factors experts believe that cap rate is not a sure shot parameter to determine your future profits. In fact, many ace real investors opt for a property with lower capitalization rates made huge profits. Factors like when you wish to take an exit from the deal or what are you actually looking for yourself from the entire investment are some of the important questions you must ask yourself.
Conclusion:
Capitalization rate (Cap rates) is not a powerful metrics for real estate industry. Factors vary over the time and most of the investors prefer lower risks over higher Cap rate on property. The capitalization rate is highly beneficial in the context when the two property you’re wishing to buy falls in the same location and within the same assets which makes Cap rates a powerful comparative tool.
In most cases, cash is not involved in the overall deal making the Cap rates lower as the interest pays a crucial role in this. Whether it is an environmental change in interest rate or an artificially adjusted interest rate, the capitalization rate is going get affected from somewhere between 0.5% to 1% which may sound negligible but is tremendous when it comes to a huge deal. Also, over time the interest over new loan would increase the annual debt which the investor has to pay resulting in higher cap rates even when the market value of the property remains the same.
Experts say, that while investing in real estate there are many factors that are responsible to give you your desired profit and you couldn’t ignore any of it. Every aspect has its own impact on your deal for which you have to dig down deeper and capitalization rate is one of them.
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