Video:How to Calculate Capitalization Rate

Transcript:How to Calculate Capitalization Rate

Hi, I'm Jen D'Amore for About.com and this video is all about how to calculate capitalization rate.

Investing in Real Estate

If you're thinking of investing in real estate, you need to run the numbers to see how  quickly you can make back your initial investment and start earning a profit. You can figure out the capitalization rate of a property similar to a property you're considering purchasing.  

Let's say you're looking at a 2 bd/ 2 bath condo as an investment, selling for $100,000.  Find a similar unit and figure out how much it costs to run, and how much it rents for. Subtract a year's worth of expenses from a year's worth of collected rent to get the net operating income.

How to Get a Capitalization Rate

To get the capitalization, or "cap," rate divide the net operating income by the sale price.

In this case $10,000 / $100,000 = .10 or 10%

You can estimate that you will make back 10% of your investment each year, and that it will take 10 years to earn back the initial $100,000 investment and start making a profit.  

If the cap rate was .05 or 5% it would take 20 years to earn back the initial investment.

If you're thinking of investing in a multi-unit complex use the same method. Find another complex of similar value, size, rental rate. Let's say your'e looking at a 10 unit complex selling for $500,000. If the net operating income is $75,000, that's one year's collected rent minus expenses, then the cap rate is .15, or 15%. So, it would take 6.6 years, or 6 years and 8 months to pay off the investment.

Cap rate is one of many tools that can help determine if an income property is worth the investment, and specifically how long it will take to truly turn a profit.

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