The importance of cap rates in real estate development

By Ian Mwaura The capitalization rate on real estate is at an all time high, as value property investments and income streams increase within the market. But what does this mean? Here is how to determine the capitalization rate, what investors should consider, and why the cap rate of land is important. The capitalization rate, more commonly known as cap rate, is the ratio of net operating income (NOI) to property asset value. It is a first-hand indicator of how much an investment is worth. If a property is listed for Sh1 million and generates an NOI of Sh100, 000, the cap rate would be 10%. Put simply: Cap rate = net operating income / Current market value (sales price) of the asset So how can you work out the capitalization rate of your potential new property?
  1. Determine the gross revenue If the land is used for agriculture, the gross income will come predominantly from the annual cash return on crop or livestock. If the land is built upon and offers a home to tenants, the gross income will likely come from rent. The gross revenue is calculated by multiplying monthly rental income by 12, to determine the income for the year.
  2. Establish the operating expenses associated with the land Any piece of developed land has operating costs. Usually, these are in the form of maintenance, insurance, taxes, and property management. Use accurate estimates for these numbers and subtract them from the gross income.
  3. Divide the net income by the property purchase price The cap rate is the ratio between the net income of the land and its original price or capital cost. Cap rate is expressed as a percentage.
There are two main reasons why the cap rate is important:
  1. It justifies the property investment opportunity The capitalization rate represents the estimated percent return an investor may make on an all-cash purchase of land. Because of this, the cap rate is a good statistic to use when comparing a potential acquisition to other land investment opportunities of a similar nature. The cap rates allow quick, rough comparisons of the earning potential of investment properties; this can help narrow down your list of choices.
  2. It determines income level of the investment property If you know the capitalization rate of land within the area of your investment property, you can use this information to determine how much net income your land will need to generate for the investment to be worthwhile. To do this, simply multiply the land’s asking price by the cap rate of similar land investments in the area, to find your recommended net income level.

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