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Capitalization Rate (Cap Rate) | Formula | Example - YouTube
Channel: WallStreetMojo
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hello everyone hi welcome to the channel
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clicking the bell icon today we have a
topic with us as capitalization rate or
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Cap rate one of the very important a
percentage or a capitalization rate
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ratio or a rate basically it's percent
rate which is used for discounting your
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cash flows so let's read couple of
things your capitalization rate usually
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is called as the cap rate which is used
in the real estate industry and it is
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the rate is the ratio of the net
operating income and the market value of
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the asset okay this was a little bit of
technical we'll try and work on this in
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a very simplistic manner
now first in the foremost thing what is
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the cap rate we will try and understand
this at the very initial stage see the
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capitalization rate is the ratio of the
net operating income and the market
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value of the asset so it is usually
called as the cap rate and is commonly
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used in the real estate industry now
capitalization rate is often used in the
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commercial real estate industry it can
be used to bear the turns it can be used
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to compare the returns of the commercial
real estate industry and it can be used
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for the potential properties up for the
acquisition the one property earning or
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one property owning a higher
capitalization rate would be considered
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a better investment than the other
property given other conditions are
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similar to that location of the building
and so on and so forth so does it allows
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the quick comparison of the earning
potential
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what earning potential of the you can
say that investment properties and you
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know it can be held it can help you to
choose the best investment opportunity
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no capitalization rate can give a sort
of an indication of a trend that can
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follow a trend of the real estate prices
of the cap rates are shrinking it may
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mean that the value of the properties
are the value of the properties are
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increasing and thus the real estate
marketer as a whole is heating up okay
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this was about the what part how what we learn about the formula
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see the capitalization rate formula the
cap rate formula is equal to your net
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operating
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income divided by the market value of
the asset this is gonna be your formula
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Cap rate is net operating income divided
by the market value of the asset so over
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here the net operating income of a
rental property it is basically what we
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call as the rent minus the expenses that
is paid for maintenance now cap rate
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formula can also be thought as of like
you know a return based is a return on
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investment and an investor will receive
annually on the purchase of the real
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estate property so that can be a thing
third what we are going to take is over
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here the example part we'll take the
first example example number one let's
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say suppose there is an office building
which gives us the net operating income
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as let's say $10 Million and it
is valued at let's say 7.5
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yeah $7.5 million dollars
let's say it is valued at 7.
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5 million dollars by using the above
cap formula we can calculate the
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capitalization rate it is as simple as
that 10 and 7.5 just
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divide both of this above you have 1.33
so if we calculate in
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terms of percentages okay so 10 divided
by 7.5 x 100 so that's
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closely around 130, 13.33%
right and those if
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the building is sold for 70 let's
hence instead of 7.5 let's
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say 75 and over here 100 then
the amount will change so 10 divided by
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75 let's say 10 million in value at
75 then
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13% is a value so if the
building is sold for $75
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million it can also proceed that
the building was so was sold at
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13% cap okay I'll take another
example example number two well let us
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have a look at the another cap rate
example let's say the rental property
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gets $1,000 gross income every month so
the owner is liable to annually pay how
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much $700 of the
property management let's say
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700 for property management let's
say 500 for
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property taxes and $250 for
insurance okay so he bought of the
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property let's say he bought the
property for let's say 80,000 so in
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this case we have a gross income and the
expenses incurred by the owner those
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will try and calculate the net operating
income of the property so over hear the
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NOI is equal to your gross income less
your property management less your taxes
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insurance part okay so noi will be is
equal to 1,000 x 12 - once you do
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that you need to deduct 700 from that
500 and less 250 deducted all these
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expenses that's 10550
so now the cap rate calculation that is
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NOI divided by the property price is
gonna be 10550 divided by he
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bought it for how much 80000
right so I will just simply write
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80000
so that's 13.18%
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right now let's try and
discuss is his cap rate always better is
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it better
see capitals can be good estimate to
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compare different investment property
but higher cap rate does not usually
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mean that better investment opportunity
cap rates are important but investor
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needs to look into the parameters as
well capitalization rate can be
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considered as a measure for the
capitalization rate can be considered as
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a measure of the riskiness of the
investment right so usually a lower cap
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rate implies low-risk a lower cap rate
implies low-risk and a higher cap rate
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implies higher risk
a comparison okay this was on this part
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let's consider the disadvantages of the
capitalization rate now can be used only
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when the net operating income is
constant or does not fluctuate much so
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by using this Cap rate is the valuation
would be somewhat similar to that from
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the DCF technique that is discounted
cash flow to however the cash flow is
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complex in irregular with the law of
variation so full discounted cash flow
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method should be used to get the credible and reliable valuations capitalization
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rate may take into account various
factors but it does not reflect the
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future risk it does not reflect the
future is so capitalization razor is
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assumes that you know a sustainable
income from the realist for a property
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but no guarantee could be made of such
an assumption so the rent may appreciate
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or depreciate so the property value may
change due to external circumstances on
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which the investor does not have any
control so the expenses such as
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maintained expense may rise and thus the cap rate does not offer any guidance on
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the production about the future risk so
let me make my final conclusion this
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particular topic after discussing so
many other topics in the same subtopics
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see capitalization rate is a comparative
metric is a comparative metric and which
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is most useful to compare similar
properties that is properties in a
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similar location so similar asset class
with similar age so the metric is still
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widely used for commercial and multi
acid real estate valuation but real
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estate investor use it too as a tool or
to value their investment in making
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informal decisions okay if they make an
informal decision however you know the
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investor should not consider cap rate as
go-to metric but also consider various
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other factors which may impact the asset
value so it is important metric but not
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an exhaustive measure so that's it for
this particular topic if you have
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