- The capitalisation rate (cap rate) is used to assess the potential return on an investment property in real estate.
- It compares the property's net operating income (NOI) to its market value.
- A higher cap rate implies a potentially higher return but also greater risk, while a lower cap rate indicates lower returns but greater stability.
Understanding capitalisation rate?
Imagine you're considering investing in a property, like an apartment building or an office complex, and you want to assess its potential return. The capitalisation rate, or cap rate, is a useful tool in real estate that helps you evaluate the income-generating potential of the property relative to its market value.
To calculate the cap rate, you divide the property's net operating income (NOI) by its market value. The NOI is the income generated by the property after deducting operating expenses like property taxes, maintenance costs, and insurance. The market value is the estimated worth of the property.
How does capitalisation rate work?
The capitalisation rate provides a simple way to compare different investment properties. A higher cap rate indicates a potentially higher return on investment but also implies greater risk. On the other hand, a lower cap rate suggests lower returns but a greater level of stability.
For example, let's say you're considering two properties:
Property A has an NOI of £50,000 and a market value of £500,000. The cap rate is calculated as £50,000 / £500,000 = 0.1 or 10%.
Property B has an NOI of £40,000 and a market value of £600,000. The cap rate is £40,000 / £600,000 = 0.0667 or 6.67%.
In this case, Property A has a higher cap rate of 10%, indicating a potentially higher return relative to its market value. However, it may also involve more risk compared to Property B, which has a lower cap rate of 6.67% but offers greater stability.
Real world example of capitalisation rate
Suppose you're interested in purchasing a rental property. You come across a residential building with an annual net operating income (NOI) of £80,000. After conducting some research, you discover that similar properties in the area typically sell at a capitalisation rate of 7%.
To determine the estimated market value of the property, you divide the NOI by the cap rate: £80,000 / 0.07 = £1,142,857. Therefore, based on the market's prevailing cap rate, the estimated value of the property would be around £1,142,857.
The bottom line
The capitalisation rate, or cap rate, is a metric used in real estate to assess the potential return on investment in a property. It compares the property's net operating income (NOI) to its market value and helps investors evaluate the profitability and value of a property. A higher cap rate suggests the potential for greater returns but also greater risk, while a lower cap rate implies lower returns but greater stability.
By understanding the cap rate, investors can make more informed decisions when evaluating investment opportunities in real estate.