Terminal capitalization rate or cap rate is an important concept to have in your real estate investing toolkit. What is the terminal capitalization rate? It is a rate utilized to estimate the total value of a property and its resale value after a period of time. The investment property’s projected gross value, expressed as a percentage, can then be used to compare between multiple real estate investments and markets.
The cap rate is usually calculated by taking the net operating income (NOI) and dividing it by the cost of the property’s original cost—including upfront expenses and repairs. The net operating income (NOI) is the income produced by the property annually after all operating expenses are deducted. Those expenses include property management taxes and fees but exclude mortgage payments. The cap rate is the expected rate of return of an investment based on the projected income of the property.
You can calculate the terminal capitalization rate by using this formula:
Terminal capitalization rate = NOI/purchase price x 100%
What makes a good cap rate?
Generally, the higher the cap rate, the better it is. For instance, if a property has an 8% to 12% cap rate, then that is generally considered a good cap rate. However, the cap rate alone does not define the profitability of a property and depends on a lot of other factors.
The most obvious factor is location and market. For example, a lower-demand area or a rural or developing neighborhood may have an average of higher cap rates. On the other hand, a lower cap rate can be the norm in high-cost and high-demand neighborhoods.
Depending on your risk tolerance, you may have a different idea of what constitutes a good capitalization rate. For instance, a property with a lower cap rate may be a better choice for the investor looking for a more stable and passive investment. It might not have extreme possibilities for growth but is in a stable location. On the other hand, if you are more willing to take a risk, a property with a higher capitalization rate may have both more risk and a higher reward, depending on the potential of the property’s appreciation.
What factors can positively influence the cap rate?
- The property’s current rental income: When you first buy a property, you want the rent to be as high as possible. This will give you a higher NOI which will give you a higher cap rate. If the rental income is not as high as you would like at the present, what you can do is add value to the property, which will help increase the rent and therefore increase the cap rate.
- Future rent: Once the value is added to a property and it is totally stabilized and operating at peak efficiency, then you can rent pro forma. This is a thorough report and breakdown that offers an idea of the estimated income and expenses and gives a better idea of what to expect once your property is operating at its best.
- Potential appreciation: Appreciation can be very difficult to predict, including knowing which neighborhoods will see steep growth and gentrification. However, there are tools available that utilize social data and artificial intelligence to more accurately tell where appreciation is occurring.
Why is the terminal capitalization rate useful?
Most importantly, you can use the terminal capitalization rate to determine the immediate profitability of an individual property. It is also a great way to compare multiple investment properties in their current state. This can be especially useful if you are considering buying one of multiple properties near each other that are part of a similar property type with similar prices. Using the terminal capitalization rate, it is easy to quickly figure out which property will generate the most income and the highest cap rate. This will quickly let you know which property will be best to invest in.
The capitalization rate can also be useful to help quickly calculate the payback period for an investment property. The capitalization rate formula offers a more accurate calculation of value because it does not include mortgage expenses. Instead, it focuses on the property alone and not on financing.
There are lots of ways to calculate returns on investment, and depending on your goals in understanding the potential value of prospective properties, the terminal capitalization rate ratio may be of use in deciding whether a property will fit your investment goals.
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