The capitalization rate is another term for rate of returns which is expected on an investment in fields of commercial real estate, this term is just a ratio of the rate of return to the actual investment made on the commercial real estate project.
What is a Capitalization Rate?
It is the ratio of net operating income and market value of the asset and is commonly used in the real estate industry.
- Capitalization Rate is often used in the commercial real estate industry. It can be used to compare the returns from potential properties up for acquisition.
- One property earning a higher rate would be considered a better investment than the other property given other conditions are similar to the location of the buildings etc. Thus, it allows for a quick comparison of the earning potential of the investment properties and can help to choose the best investment opportunity.
- It can give a sort of indication of the trend of real estate prices. If the rates are shrinking, it may mean that the value of the properties is increasing, and thus the real estate market as a whole is heating up.
Capitalization Rate Formula
Below is the formula used for the calculation
- The Net Operating Income of a rental property is its rent minus the expenses paid for its maintenance.
- It can also be thought of as return on investment an investor will receive annually on the purchase of real estate property.
Capitalization Rate Examples
Suppose an office building which gives a net operating income of $ 10,000,000 is valued at $ 75,000,000. Using the above cap rate formulaCap Rate FormulaThe cap rate formula is calculated by dividing the net operating income by the asset's current market value. The investors use it to evaluate real estate investment based on the return of one year. It helps to decide whether a property is a good deal. Formula = Net operating income/Asset's current market value, we can calculate the capitalization rate of the building is:
= 10000000/75000000 = 13.33%
Thus, if the building is sold for $ 75 Mn, it can also be said that the building was sold at a 13.33% capitalization rate.
Let’s say a rental property gets $ 1,000 gross income every month. The owner is liable to annually pay $ 700 for property management and maintenance, $ 500 for property taxes, $ 250 for insurance. He bought the property for $ 80,000.
In this case, we have the gross income and the expenses incurred by the owner. Thus, we will calculate net operating incomeNet Operating IncomeNet Operating Income (NOI) is a measure of profitability representing the amount earned from its core operations by deducting operating expenses from operating revenue. It excludes non-operating costs such as loss on sale of a capital asset, interest, tax expenses. on the property:
- NOI = Gross Income – property management – property taxes – insurance
- NOI = 1000*12 – 700 – 500 – 250
- NOI = 12000 – 1450 = $ 10550
- Now, capitalization Rate Calculation = NOI/Property price = $10,550/$80,000 = 13.18%
Is High Capitalization Rate Always Better?
- Capitalization rates can be a good estimate to compare different investment properties. But a higher rate does not usually mean a better investment opportunity. Cap rates are important, but an investor needs to look into other parameters as well.
- It can be considered as a measure of the riskiness of the investment. Usually, a low rate implies low risk, and a higher rate implies higher risk.
Disadvantages of Capitalization Rate
- It can be used only when the net operating income is constant or does not fluctuate much. By using this capitalization rate, the valuation would be somewhat similar to that from the discount cash flow method. However, if the cash flow is complex and irregular with a lot of variation, a full discounted cash flow method should be used to get a credible and reliable valuation.
- The Capitalization Rate may take into account various factors, but it does not reflect the future risk. It assumes a sustainable income from the real estate property, but no guarantee could be made to such an assumption. The rent may appreciate or depreciate. The property value may change due to external circumstances on which the investor does not have any control. Expenses such as maintenance expenses may arise. Thus, the capitalization rate does not offer any guidance or prediction about future risk.
Capitalization Rate is a comparative metric that is most useful to compare similar properties i.e., properties in a similar location, similar asset class, and similar age. This metric is still widely used for commercial and multi-asset real estate valuations. Real estate investors use it as a tool to value their investments and make an informed decision. However, the investor should not consider capitalization rates as a go-to metric but also consider various other factors that may impact the asset value. It is an important metric but not an exhaustive measure.
Capitalization Rate Video
This article has been a guide to What is Capitalization Rate? Here we discuss the Capitalization Rate Formula along with practical examples, advantages, and disadvantages. You can learn more about Financial Analysis from the following articles –