What is Capitalization Rate?
The capitalization rate is another term for the rate of returns expected on an investment in fields of commercial real estate. This term is a ratio of the rate of return to the actual investment made on the commercial real estate project. It is the ratio of net operating income and asset market value and is commonly used in the real estate industry.
The capitalization rate calculator 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 informed decisions. However, the investor should not consider them as a go-to metric but also consider various other factors that may impact the asset value. It is an important metric but not a specific measure.
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Capitalization Rate Explained
Capitalization Rate is often used in the commercial real estate industry. It can compare the returns from potential properties up for acquisitionAcquisitionAcquisition refers to the strategic move of one company buying another company by acquiring major stakes of the firm. Usually, companies acquire an existing business to share its customer base, operations and market presence. It is one of the popular ways of business expansion..
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 investment properties’ earning potential and can help 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 is heating up.
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.
It can be considered as a measure of the riskiness of the investment. Usually, a low rate implies low risk, and a higher rate indicates higher risk.
Capitalization Rate is a comparative metric that is most useful to compare similar properties i.e., properties in a similar location, similar asset classAsset ClassAssets are classified into various classes based on their type, purpose, or the basis of return or markets. Fixed assets, equity (equity investments, equity-linked savings schemes), real estate, commodities (gold, silver, bronze), cash and cash equivalents, derivatives (equity, bonds, debt), and alternative investments such as hedge funds and bitcoins are examples., and similar age.
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Explanation Video of Capitalization Rate
Let us understand the formula for the capitalization rate calculator in detail through the explanation below.
- 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.
Let us understand the concept of real estate capitalization rate with the help of a couple of examples as discussed below.
Suppose an office building that 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 IncomeGross IncomeThe difference between revenue and cost of goods sold is gross income, which is a profit margin made by a corporation from its operating activities. It is the amount of money an entity makes before paying non-operating expenses like interest, rent, and electricity. – 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%
Let us understand the advantages of the real estate capitalization rate through the points below.
- It helps investors gauge different investment options. If there are more than properties with different rates of return, they can calculate and find the option that gives them better returns.
- It also helps investors take benefit from the trends. If the rental rates are going to increase, they can take that call and make the most of the opportunity.
- It can be used as a support metric to be used with other such metrics such as cash flow analysis of the property and so on.
Despite the advantages mentioned above, there are factors that prove to be hurdles for investors. Let us understand the disadvantages of the capitalization rate through the discussion below.
- It can be used only when the net operating income is constant or does not fluctuate much. Using this capitalization rate, the valuation would be somewhat similar to the discount cash flow methodDiscount Cash Flow MethodDiscounted cash flow analysis is a method of analyzing the present value of a company, investment, or cash flow by adjusting future cash flows to the time value of money. This analysis assesses the present fair value of assets, projects, or companies by taking into account many factors such as inflation, risk, and cost of capital, as well as analyzing the company's future performance.. However, if the cash flow is complex and irregular with many variations, a fully discounted cash flow method should be used to get a credible and reliable valuation.
- The Capitalization Rate may consider 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 over which the investor does not control. Expenses such as maintenance expenses may arise. Thus, the capitalization rate does not guide or predict future risk.
This article has been a guide to what is Capitalization Rate. Here we explain the capitalization rate formula and practical examples, advantages, and disadvantages. You can learn more about Financial Analysis from the following articles –