Capitalization Rate ( Cap Rate)

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?

The capitalization rate is the ratio of net operating income and market value of the asset. It is usually called the cap rate 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 capitalization 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.
• Capitalization Rate can give a sort of an indication of the trend of real estate prices. If the cap rates are shrinking it may mean that the value of the properties are increasing and the thus real estate market as a whole is heating up.

Cap Rate Formula

Below is the Cap Rate Formula used for calculation

• Net Operating Income of a rental property is its rent minus the expenses paid for its maintenance.
• Cap rate formula can also be thought of as return on investment an investor will receive annually on the purchase of real estate property.

Capitalization Rate Examples

Example 1

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 formula, 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 13.33% cap rate.

Example 2

Let us have a look at another cap rate example.

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 income on the property:

• NOI = Gross Income – property management – property taxes – insurance
• NOI = 1000*12 – 700 – 500 – 250
• NOI = 12000 – 1450 = $ 10550
• Now, Cap Rate Calculation = NOI/Property price = $10,550/$80,000 = 13.18%

Is High Capitalization Rate Always Better?

• Cap rates can be a good estimate to compare different investment properties. But a higher Capitalization Rate does not usually mean better investment opportunity. Cap rates are important but an investor needs to look into other parameters as well.
• Capitalization Rate can be considered as a measure of the riskiness of the investment. Usually, a low cap rate implies low risk and a higher rate implies a 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 cap rate the valuation would be somewhat similar to that from 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.
• Capitalization Rate may take into account various factors but it does not reflect the future risk. Capitalization Rate 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 investor does not have any control. The expenses such as maintenance expense may arise. Thus, the cap rate does not offer any guidance or prediction about future risk.

Conclusion

Capitalization Rate is a comparative metric which is most useful to compare similar properties i.e. properties in similar location, similar asset class and with 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 cap rates as a go-to metric but also consider various other factors which may impact the asset value. It is an important metric but not an exhaustive measure.

Capitalization Rate ( Cap Rate) Video

Recommended Articles

This has been a guide to What is Capitalization Rate? Here we discuss the Cap Rate Formula along with practical examples,  advantages, and disadvantages. You can learn more about Financial Analysis from the following articles –

• Overcapitalization | Definition
• Explanation of High-Low Method Formula
• Discounted Cash Flow Formula
• Formula to Calculate Free Cash Flow
• Net Operating Loss
• NOPAT
• Direct vs Indirect Cash Flow Methods
• Free Cash Flow Yield