How to Calculate Capitalization Rate

calculate capitalization rate

Actually, there are many version used to measure capitalization rate value. The most popular version to calculate capitalization rate of a property investment is measured by dividing net operating income (NOI) by the recent value of the property. Mathematically, the formula is shown below:

Capitalization Rate = Net Operating Income (NOI) / Current Market Value

What is Net Operating Income (NOI)? The value of net operating income (NOI) is generated by alleviating the expected annual income with all the cost spent in order to maintain the facility and the property building.  Not only expenses to do regular up keep to the facility around and inside the building property, but also the cost spent for paying taxes.

calculate capitalization rate
calculate capitalization rate

The (expected) annual income can be generated by renting the commercial building property to the tenants. If the tenants only rent the building for less than a year, than you have to sum up the monthly income you get until one year.

The Formula

The current market value is the recent value of the building property in market rates which valid in the present day. You can also replace the current market value by using the acquisition expense of the building property or the original capital cost. This is shown in the formula below:

Capitalization Rate = Net Operating Income (NOI) / Purchase Price

The second version is the simplest way to calculate capitalization rate (Cap rate) since you don’t need to search the recent price of the property. You only need to calculate all the expense you have spent to do regular upkeep to the facility and the cost for paying the tax which then called as Net Operating Income (NOI). Then you only need to divide the NOI value with purchase price of the property.

calculate capitalization rate
calculate capitalization rate

Despite this version is simpler than the previous version, the second formula is uncommon in real estate property business. There are two main reasons why this version or formula is not popular to be used in real estate property business.

The first reason is because this formula gives unrealistic calculation of capitalization rate since the purchase price used in the computation is outdated. The real estate property can be purchased in several years or maybe decades ago. Thus it causes the price very low compared to the real recent price of the property.

The second reason why we don’t use this capitalization rate formula because the formula is not giving the accurate representation of the current market value. Whereas we know that property prices fluctuate annually, using fixed purchase price to compute capitalization rate is illogical.

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