The capitalization rate is Definition, calculation features and examples

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

Real estate investors use various indicators in their own activities. This applies to the valuation of objects that generate income. For example, you may be interested in the location of the facility or any upcoming changes in the area. The capitalization rate is one of the most important indicators that has a direct impact on decision-making in the field of real estate. Using it, investors compare different objects, making an assessment of the potential profit.

Definition

What is the capitalization rate? This ratio is the ratio of the purchase price of the object and net profit. By calculating this, investors calculate the ratio of the market value of the object and the net income that it brings during the year.

As a result of the datacalculations, it is possible to find out the percentage of income that can be obtained by acquiring a particular asset. It should be noted that the capitalization rate is a rather controversial indicator for Russian realities. It is not always possible to accurately calculate it. This is due to the lack of statistical information in the real estate market.

Application

The capitalization rate is a measure that is used to bring income streams to a single value. In economics, this ratio provides information about the rate of return that the investor will receive, taking into account some risks, as well as a possible change in the value of the object.

In Russia, this method of payment is rarely used. This is due to the fact that reliable information can be obtained only if the object being assessed (for example, an enterprise) brings stable income.

What do you need?

So you know what the capitalization rate is. However, this is not all you need to know. The above ratio allows for a quick comparison of investment opportunities. Usually it is expressed as a percentage of the profit that the investor is promised by the acquisition of real estate. That is why this indicator is ideal for comparing several investment options that are similar to each other. Using the capitalization rate, you can quickly compare the level of potential income and in this way reduce the number of actual options.

The capitalization rate allowsdetermine income level. If you know this ratio in any area, it will not be difficult to calculate the net profit that will need to be received for a return on investment. It is enough to multiply the cost of the object and the capitalization rate. This will reveal the approximate level of rental rates, below which the potential owner should not lower the bar. Using this method of payment, you can make a decision on the expediency of the transaction

Important to know

Specialists do not recommend considering the capitalization rate as the only factor of investment viability. This indicator makes the comparison more convenient. However, you need to understand that real estate investment is a rather complicated area that requires a more detailed approach. Even simpler investments are subject to market and contingency.

Before purchasing, you need to make sure that the investment property will generate income. It is also important to calculate possible costs, changes in the value of the object and other factors that affect the situation.

Risks

You need to understand that the capitalization rate does not reflect the likelihood of any risks. You should not take this ratio as a guarantee that the value of income or the current level of income will remain unchanged throughout the entire period of time. Both rent and property price may increase or vice versashrink. According to experts, the capitalization rate does not contain information about such changes. That is why the calculations must be more subtle. A potential investor should consider as much information as possible.

Calculation features

Assume that the capitalization rate will be used to assess the investment attractiveness of a property:

1. First of all, you need to calculate the annual income. As a rule, this is the profit that the rent brings. However, this is not the only potential source of income. That is why, for more accurate calculations, you need to collect detailed information about the property.
2. Any object brings to its owner not only income, but also expenses. They are also important to consider. These are usually the costs of insurance, taxes, maintenance of the facility, etc. They must be deducted from the annual income. In this way, the so-called net profit is calculated. An important nuance is that in these calculations, the costs include the costs of acquiring real estate, as well as paying interest on a loan. Otherwise, the calculations will be incorrect.
3. Now it remains to use the formula, according to which, to determine the capitalization rate, you need to divide the net income by the value of the property.

Examples

Let's try to calculate the capitalization rate for a property:

1. If the costrent is a conditional thousand rubles, then in a year a potential investor can earn twelve thousand rubles in this way.
2. Next, subtract the costs incurred by the maintenance of the property. If they amount to conditional two thousand rubles, then the net profit will be ten thousand rubles.
3. If we assume that a potential investor purchased an object for conditional two hundred thousand rubles, then the capitalization rate in our example will be twenty percent.

Agree, the calculations are quite fast and relatively simple. It is for this reason that this coefficient is convenient to use for a quick comparison of several options.

Interest rate with capitalization

This term also needs some explanation. First of all, we will inform you that this concept is relevant in the banking sector. For example, when opening a deposit.

Capitalization of the deposit involves adding interest to the initial amount of the deposit. This will lead to higher profits in the future. Even if the bank offers a standard rate for deposits with capitalization, in the end the client manages to get a higher income. This is due to the fact that interest will be charged on a large amount. It includes not only the initial deposit amount, but also the accrued amount.

It is worth noting that many banks offer deposits with interest capitalization rates. Therefore, it will not be difficult to find such offers and increase your own capital in such an absolutely simple way.

Very important to considerthe fact that the interest on the deposit must be calculated every day. However, capitalization is calculated depending on the conditions specified in the agreement concluded between the bank and the client.

That's why you need to pay special attention to this item. The more often capitalization occurs, that is, the addition of accrued interest to the total amount of the deposit, the faster your income on the deposit increases. However, Russian banks do not offer daily capitalization to their clients. As a rule, at best, this process is carried out monthly. Under the conditions of some credit institutions, capitalization is carried out even less frequently. For this reason, customers may receive less income. That is why it is so important to be well informed about the terms of the contract.

If the annual rate with capitalization is indicated, it will usually be higher than for other offers. That is why such contributions can be determined even if you do not read the conditions. To calculate potential income, you can use specialized calculators on the website of banks or third-party services. It is better to count several times to get accurate results.