Capitalization 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?

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 Formula

Below is the formula used for the calculation

Capitalization rate

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For eg:
Source: Capitalization Rate (wallstreetmojo.com)

  • 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

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 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 valueread more, 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.

Example 2

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.read more on the property:

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

Conclusion

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.read more, 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 –

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