A big question that bothers any real estate investor, when they are about to buy a property is the question “Is it worth the money?”—Real Estate investments are expensive, and it is only natural that you are concerned about the return on investment. Here’s why you need to know about the concept of the Capitalisation rate.
Things we covered for you
+
What is Capitalisation Rate (Cap-rate)?
Capitalisation Rate or Cap Rate measures the rate at which the property you purchased will pay for itself.
Say you purchased a new home for ₹30 Crore. The capitalisation rate will indicate the rate at which the rental will give you back the money you put in for buying the home.
How is the Capitalisation Rate of a Property determined?
Capitalisation rate factors in three economic variables, namely–
- the opportunity cost of the capital
- growth expectation and
- risk
Benefits of Knowing Cap Rate
Here are the benefits of knowing the Cap Rate.
1. You can Estimate Your Potential Returns
The cap rate is an essential financial indicator in the real estate industry because it makes it easy for investors to figure out how much money they could make from an investment.
In contrast to return on investment, which looks at present earnings, the cap rate takes into account the possibility that an asset will be bought in the future.
A cap rate is a key number you can use to compare different real estate options and figure out how much money you can expect to make in the future.
2. Cap rate is a better way to compare Investment Opportunities
The cap rate is a great way to compare different properties. Using the cap rate calculation, an investor might look at several homes to see which one might make the most money as a rental property.
Because of this, the cap rate is a very important tool for helping investors find the best ways to make the most money.
3. You can know how long it will take for returns.
The cap rate can also give you an idea of how long it might take to get the expected return. This is because the cap rate figures out the possible returns over a year, so you can use the percentage to figure out how long the investment will last.
For instance, if an investor looks at a home with an 8% cap rate, they might expect to get their money back in full after eight years. It’s important to remember that the cap rate is just an estimate, and it can change depending on how the market changes, how much property taxes go up or down, and how much maintenance or repairs cost.
4. It will give you a better idea of the risk of an investment.
By figuring out the cap rate, real estate investors can also get an idea of how risky each investment option is. For example, estimating a higher market cap can often mean that the risk is higher while estimating a lower market cap can sometimes mean that the risk is lower.
Even though the cap rate doesn’t tell you exactly how risky an investment is, it can be a good way to figure out how risky a certain investment property might be.
All things considered; you must not rely purely on the cap rate to consider if an investment is worth it.
The Formula for Calculating the Cap Rate of a Property
You can calculate the cap rate of a property by dividing its net operating income(NOI) by its current market value.
Net Operating Income (NOI)
The net operating income is a measure used to analyse the profitability of an income-generating real estate investment.
NOI does not factor in
- the principal and interest payments on the loans
- Capital expenditures
- Depreciation.
In other words, the NOI is the earnings on the real estate property before interest and taxes.
Here’s how you can calculate the NOI—
Subtract all operating expenses on the property from the revenue generated on the property, and you have the NOI.
NOI Formula
Net operating income of a property is equal to the total revenue it earns minus the operating expenses.
Let’s consider an example.
Read: Auspicious Dates for Property Registration in 2024 With Nakshatra & Tithi
Book Best Packers & Movers with Best Price, Free Cancellation, Dedicated Move Manager
This is third
This is third
This is fourth
This is fourth
This is fifth
This is fifth
This is six
This is six
This is seven
This is seven
This is eight
This is eight
Total Revenue.
Rent = ₹35000
Monthly Parking Charges =₹300
Total Revenue =₹35800.
Operating Expenses
Property Management Fees = ₹700
Property Tax = ₹4950
Repair and Maintenance charges =₹4000
Insurance= ₹1500
Total Operating Expense = ₹11150.
Net Operating Income = ₹35800- ₹11150 = ₹24650
NOI of a rental property
A rental income may generate multiple income streams such as
- Parking structures,
- Vending machines
- Laundry facilities…
Operating expenses of a rental property include – legal fees, fees on electrical and plumbing repair, and air conditioning system maintenance costs.
You can subtract operating expenses from the income streams to calculate the NOI.
NOI for Financed Properties
In the case of Financed properties, a Debt Coverage ratio is used instead of NOI. This helps inventors get an idea of how quickly the property recovers its operating expenses and debt payments.
The Ideal Capitalisation Rate for a Rental Property
There is no formula to calculate what constitutes a good cap rate.
If you are in a high-demand location, a Cap rate of 6–7% can be considered a good investment opportunity.
A higher cap rate means that effectively you are paying a lower value for the property that you are going to buy. But if you are going to sell a property, a lower cap rate is more favourable.
Factors Affecting the Cap Rate
Here are some key elements that affect cap rates in the Indian real estate market:
1. Location:
Prime locations with high demand, such as city centres or established commercial areas, tend to command lower cap rates due to their perceived stability and potential for higher rental income. Meanwhile, properties in less desirable or emerging areas may have higher cap rates to compensate for the associated risks.
2. Rental Market Conditions
Factors such as vacancy rates, rental growth, and supply and demand dynamics affect the income potential of a property.
Cap rates are lower in markets with high demand and low vacancy rates as investors are willing to accept lower returns for stability and potential appreciation.
3. Property Type
Different types of properties, such as residential, commercial, retail, or industrial, have varying cap rates. This discrepancy is primarily driven by factors like market demand, tenant quality, and the specific characteristics of each property type.
Read: Top Rated Construction Companies in Hyderabad
For instance, commercial properties in prime locations often have lower cap rates compared to residential properties due to higher rental rates and longer lease terms.
4. Property Condition
The condition of the property influences its cap rate.
Well-maintained properties with modern amenities and good infrastructure tend to command lower cap rates, as they are perceived to have higher rental demand and potentially lower maintenance costs. Conversely, properties in poor condition or requiring significant repairs may have higher cap rates to account for the associated risks and costs of renovation.
5. Economic Factors
General economic conditions, such as interest rates, inflation, and market stability, can impact cap rates. Lower interest rates may lead to increased demand for real estate investments, potentially driving down cap rates. Conversely, economic instability or rising inflation can increase cap rates as investors seek higher returns to compensate for the perceived risks.
6. Investor Preferences and Risk Appetite
Investor preferences and risk appetite also influence cap rates. Some investors may prioritize stable, low-risk investments and be willing to accept lower cap rates for properties with secure income streams. Others may seek higher returns and be more inclined to invest in properties with higher cap rates but potentially higher risk.
Read: Everything You Need to Know About Land Measurement Units in India
Limitations of Capitalisation Rate
Don’t rely solely on the capitalisation rate has its limitations.
The cap rate is useful as long as the property’s income remains steady in the long run. It is not so useful when the property produces an inconsistent cash flow.
When using the Cap rate, keep in mind that it overlooks potential future risks, such as
- depreciation
- or structural changes in the rental market
which can lead to fluctuations in income.
You must consider these risks when relying solely on cap rate calculations.
4 Actions to Maximize Your Rental Property’s Cap Rate
- Upgrade and renovate the property to make it more appealing to tenants.
- Implement effective property management practices to optimize rental income and minimize expenses.
- Stay informed about the rental market and adjust rental rates accordingly.
- Reduce costs by efficiently managing expenses related to maintenance, energy, and insurance.
Anytime you are buying a property, make it a point to assess the value of the property from the perspective of the Capitalisation rate.
At the same time, keep in mind that the cap rate is only one of the ways of assessing the returns on a real estate investment.
Thorough deliberative research and due diligence on the ownership history of the property will help in maximising the returns that you get from your property.
You can Call NoBroker’s Property Experts to buy the highest returns properties in India.
Read: Duplex House in India: For Those Who Want to Live Double the Life!
FAQs
1. What is the formula for calculating Capitalisation Rate?
You can calculate the capitalisation rate by dividing the Net operating income by the market value of the property—
Capitalisation Rate= Net Operating IncomePurchase Price
—where the NOI(Net Operating Income) is the income obtained from the property minus any taxes or other expenses that you have to pay to maintain your property.
2. What would be considered a good capitalisation Rate in India?
Anything between 5-10% is considered a good cap rate as per analysts. Keep in mind – a lower cap rate is indicative of lesser risk, but a longer investment recovery time.
3. What is the difference between capitalisation rate and yield?
Both capitalisation rate and yield are useful measures to consider if you are going to buy a property. Generally, it is better to buy properties with higher yields and higher capitalisation rates as both are indicative of higher returns.
The difference between the two terms is this– while cap rate only considers the market value(dynamic) of the property at the time of purchase, the yield considers the total cost of the property and not the static market value.
4. Is a higher cap rate always better?
If you have to choose between two properties, it is better to buy the property with the higher capitalization rate(cap rate). This is because the capitalization ratemeasures the earning potential of the property. The higher the capitalisation rate, the better the earning potential.
Generally, it is always better to buy a property with a higher capitalisation rate than to buy
5. What are the benefits of having a higher capitalisation rate?
If you know the capitalisation rate of a property you can easily determine whether or not you should buy the property. Knowing the capitalisation rate will also help you compare different types of investments– say between buying a property and investing in a treasury bond.
6. What is a good capitalisation rate for rental property in India?
5-10% is typically considered a good capitalisation rate for rental properties in India. Cap rate of rental property varies on the basis of factors like, Location, Type of property(commercial vs residential), condition of the property and the current state of the real estate market
