Capitalization Rate Definition Explained Perfectly
Real estate is one of the best investments you can make. For a long time, real estate has been considered a great way to invest and make money. This is mainly because real estate usually increases in value, as long as you are smart about your purchases.
There can be some downsides to real estate investment and you should learn as much as you can in an effort not to make poor choices. One of the key terms you should understand and consider when making decisions about real estate is capitalization. This is an important term for anyone that wants to buy real estate as an investment. Continue reading this article to find out more information about all things capitalization.
What is Capitalization Rate?
Capitalization rate is a term that is often used in real estate to determine if a property is a good investment. The term is often shortened to cap rate and it helps you determine the net operating income of the property you want or have.
This is also how you determine how much return you can earn on your property. When you purchase something as an investment, the entire point is to make money. If you do not make money, it is a bad investment for you. The cap rate helps you determine how much money you might make. This is not the only factor that should go into your decision about purchasing an investment, but it is an important one.
The number is always presented as a percentage. It is a fairly simple number to determine. You take the net operating income of the property and divide it by the current value. The net operating value is how much money you make from the property after you have paid all of the expenses. This is the money you walk away with as profit.
An easy example is:
Your net operating income is $10,000 and the value of the property is $500,000, then the cap rate is 20 percent.
If your net operating income on the same investment is $50,000, then your cap rate is 10 percent.
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Why is the Capitalization Rate Important?
The capitalization rate is important because it can help you determine how much risk there might be for you when you purchase an investment. If you use the cap rate alone, it may not give you the full picture, but it is a starting point at which you can determine if you should continue to consider a piece of property as an investment.
It is important for you to understand how much risk is associated with a particular investment you would like to make. This is the best way for you not to go into the purchase of property unaware. If you are new to investing in property, you want to take smart steps in an effort not to completely lose all your money.
While investing in real estate can be a simple way to invest, it is not always easy. You can make a lot of mistakes that can cost you greatly. The best way to prevent that is to learn as much as you can and understand how numbers like the cap rate are important to your decision.
What Goes Into Determining the Capitalization Rate?
One of the key numbers in determining the capitalization rate is the current market value of the property in which you are considering, or currently own. There are many factors that go into the current market value price that can drive it up or down.
Real estate can fluctuate based on the market. When the market is good, the prices of real estate go up. When you hold on to a property for a longer time, you will own more of it, owe less on it, and therefore make more money when you sell it, especially if you can wait until a time when the market is doing really well. It is important for you to understand the cap rate at any given time.
The age of the property makes a difference in your cap rate along with the location of the property. These items factor into the market value of the property.
The condition of the property also makes a difference on the current value.
The amount of money that you owe on the property makes a difference on your return net operating income. The more money you pay on it, then the lower your operating income will be.
These factors are changeable, which also makes the cap rate changeable and it is important for you to understand that before making a decision.
What is a Good Capitalization Rate?
It is possible for the same capitalization rate to be good or bad, depending on how you plan to use it.
When Buying
If you are planning to sell the property, then you want a lower cap rate. A lower cap rate indicates that the value of the property is high.
When Selling
If you are buying a property, you want the cap rate to be higher because this means you will have a lower investment cost.
The amount of time you plan to keep the property also determines if the cap rate is good for you. When a property has a cap rate of 10 percent, it will take you about 10 years to make back the money you invested in the property. If you only want to keep the property for 5 years, this may not be the best cap rate for you.
In general terms, a cap rate that falls between 4 percent and 12 percent is considered to be a good cap rate for investments.
However, it is important to understand what goes into determining the cap rate for a certain area, as well as realizing that the rate can change.
What is Over Capitalization?
In general, when it comes to real estate investment, the thought is you purchase it at a low price, you hold onto it for a while, you make some improvements and then you sell it for more than you purchased it. That is one way to make money from a real estate investment.
Another way is to make money while you are holding onto it, which could be through rent. The goal is to get as much return on your investment as quickly as possible. However, if you do too much to the property, you run the risk of overcapitalization.
This occurs when you have done so much to the house but you have not increased the overall value at the same rate as your upgrades. Many people find themselves in this position. There is a limit to how much you are going to be able to sell a property.
Be Smart with the Upgrades
If you purchase a property for $200,000 and you know the houses in the area are selling for $280,000, you can reasonably think that with the right upgrades, you can sell your property for that much, and maybe, just maybe a little more. Chances are you are not going to be able to sell your house for $380,000. This means that you need to be smart with your upgrades. You should do the upgrades that will give you the most return, usually kitchens and bathrooms, but stay within the range of for much can you really sell the house.