Capitalization Rate

What is a Capitalization Rate?

The capitalization rate (also known as cap rate) is used in the world of commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property. This measure is computed based on the net income which the property is expected to generate and is calculated by dividing net operating income by property asset value and is expressed as a percentage. It is used to estimate the investor’s potential return on their investment in the real estate market.

While the cap rate can be useful for quickly comparing the relative value of similar real estate investments in the market, it should not be used as the sole indicator of an investment’s strength because it does not take into account leverage, the time value of money and future cash flows from property improvements, among other factors. There are no clear ranges for a good or bad cap rate, and they largely depend on the context of the property and the market.

What Does Capitalization Rate Mean?

What is the definition of capitalization rate? The cap rate is one of the most important concepts in real estate investing as it provides an indication of the rate of return based on the net operating income of a property and its current market value. The net operating income is the income that remains after deducting property taxes, maintenance costs, and other operating expenses from the gross operating income, except for depreciation expenses.

To calculate the capitalization rate formula of a real estate investment, we need to know the current market value and the net operating income of the property. The higher the cap rate is, the higher the return on investment.

Capitalization rate shows the potential rate of return on the real estate investment. The higher the capitalization rate, the better it is for the investor. Net operating income, one of the metrics to compute the cap ratio, is found by deducting the operating expenses from the gross operating income.

The operating expenses can be property taxes, maintenance costs, etc. Operating expenses however does not include depreciation. Capitalization rate gives the first hand indicator of the investment worthiness of the asset. However, it is not an exhaustive measure by itself.

When, and When Not, to Use a Cap Rate

The cap rate is a very common and useful ratio in the commercial real estate industry and it can be helpful in several scenarios.  For example, it can and often is used to quickly size up an acquisition relative to other potential investment properties.  A 5% cap rate acquisition versus a 10% cap rate acquisition for a similar property in a similar location should immediately tell you that one property has a higher risk premium than the other.

Another way cap rates can be helpful is when they form a trend.  If you’re looking at cap rate trends over the past few years in a particular sub-market then the trend can give you an indication of where that market is headed.  For instance, if cap rates are compressing that means values are being bid up and a market is heating up. Where are values likely to go next year?  Looking at historical cap rate data can quickly give you insight into the direction of valuations.

While cap rates are useful for quick back of the envelope calculations, it is important to note when cap rates should not be used. When properly applied to a stabilized Net Operating Income (NOI) projection, the simple cap rate can produce a valuation approximately equal to what could be generated using a more complex discounted cash flow (DCF) analysis. However, if the property’s net operating income stream is complex and irregular, with substantial variations in cash flow, only a full discounted cash flow analysis will yield a credible and reliable valuation.

Capitalization Rate Formula

Several versions exist for the computation of the capitalization rate. In the most popular formula, the capitalization rate of a real estate investment is calculated by dividing the property’s net operating income (NOI) by the current market value. Mathematically,

Capitalization Rate = Net Operating Income / Current Market Value

The net operating income is the (expected) annual income generated by the property (like rentals) and is arrived at by deducting all the expenses incurred for managing the property. These expenses include the cost paid towards the regular upkeep of the facility as well as the property taxes.

The current market value of the asset is the present-day value of the property as per the prevailing market rates.

In another version, the figure is computed based on the original capital cost or the acquisition cost of a property.

Capitalization Rate = Net Operating Income / Purchase Price

However, the second version is not very popular for two reasons. First, it gives unrealistic results for old properties that were purchased several years/decades ago at low prices, and second, it cannot be applied to the inherited property as their purchase price is zero making the division impossible.

Additionally, since property prices fluctuate widely, the first version using the current market price is a more accurate representation as compared to the second one which uses the fixed value original purchase price.

Example

For example, if a building is purchased for $1,000,000 sale price and it produces $100,000 in positive net operating income (the amount left over after fixed costs and variable costs are subtracted from gross lease income) during one year, then:

$100,000 / $1,000,000 = 0.10 = 10%

The asset’s capitalization rate is ten percent; one-tenth of the building’s cost is paid by the year’s net proceeds.

If the owner bought the building twenty years ago for $200,000 that is now worth $400,000, his cap rate is

$100,000 / $400,000 = 0.25 = 25%

It’s important for the investor must take into account the opportunity cost of keeping his money tied up in this investment. By keeping this building, he is losing the opportunity of investing $400,000 (by selling the building at its market value and investing the proceeds). This is why the current value of the investment, not the actual initial investment, should be used in the cap rate calculation. Thus, for the owner of the building who bought it twenty years ago for $200,000, the real cap rate is twenty-five percent, not fifty percent, and he has a 400,000 dollars invested, not 200,000.

As another example of why the current value should be used, consider the case of a building that is given away (as an inheritance or charitable gift). The new owner divides his annual net income by his initial cost, say,

$100,000 (income)/ 0 (cost) = UNDEFINED

Anybody who invests any amount of money at an undefined rate of return very quickly has an undefined percent return on his investment.

From this, we see that as the value of an asset increases, the amount of income it produces should also increase (at the same rate), in order to maintain the cap rate.

Capitalization rates are an indirect measure of how fast an investment will pay for itself. In the example above, the purchased building will be fully capitalized (pay for itself) after ten years (100% divided by 10%). If the capitalization rate were 5%, the payback period would be twenty years. Note that a real estate appraisal in the U.S. uses net operating income. Cash flow equals net operating income minus debt service. Where sufficiently detailed information is not available, the capitalization rate will be derived or estimated from net operating income to determine cost, value or required annual income. An investor views his money as a “capital asset”. As such, he expects his money to produce more money. Taking into account risk and how much interest is available on investments in other assets, an investor arrives at a personal rate of return he expects from his money. This is the cap rate he expects. If an apartment building is offered to him for $100,000, and he expects to make at least 8 percent on his real estate investments, then he would multiply the $100,000 investment by 8% and determine that if the apartments will generate $8000, or more, a year, after operating expenses, then the apartment building is a viable investment to pursue.

How is the Cap Rate used?

The cap rate is a metric that a buyer can use to compare the price of an asset in the market with other similar properties that have sold in the last 6 months (or longer) and to track trends in the market over set periods of time. Buyers use the cap rate as a way to determine if they are getting a deal on a property they are looking to purchase by comparing it to the prior sales prices of other similar properties in the market. Brokers and sellers use cap rates as a sales tool to attract buyers to the asset by showing transparently how they priced the asset and to entice interested parties with an asset’s potential yield.

Are Cap Rates only used when looking at the purchase price of an asset?

Cap rates can also be used to quickly estimate a property’s value when considering a refinance. If a property owner wants to consider a refinance, they may need an estimated value to determine what potential loan amount the property supports using the lender’s loan to value (LTV) metric. Once the estimated value is calculated, the owner can determine whether a refinance is possible, or even worth it.

Are there any other ways to use Cap Rates?

Some buyers use future estimated cap rates to model the projected return of a property before it is purchased. A financial “model” is put together in excel to determine a project’s projected return profile and to see if it meets the buyer’s return targets. The model uses the purchase price, closing costs, the senior debt, projected income and expenses with growth over the anticipated hold period, as well as a projected exit price and potential profit. In order for a buyer to complete the data inputs in a model and reach a projected internal rate of return (IRR), many unknown figures must be assumed using available market data.  For example, Axiometrics, a provider for multifamily data, issues reports that show what the projected market rent growth is in a submarket so buyers can incorporate those rent growth numbers into their model.  CoStar, another commercial real estate data provider, offers historic cap rates for markets and submarkets which helps buyers determine reasonable cap rates for that market when estimating the exit price of the asset at the end of the projected hold period.

While Cap Rates are a useful metric, they should not be relied upon solely when analyzing an investment property, and have certain shortcomings that will be explored in part two of this series. Part three of the series will describe why cap rates are inappropriate for value-add transactions, and the final piece in the series will answer the question ‘what should my target cap rate be?’.

What makes a good or bad capitalization rate?

Cap rates are determined by anticipated future income, which can be unsteady and vary greatly. A good cap rate depends on two things: what you are looking to get out of an investment and how much you are willing to risk for it.

A higher cap rate is indicative of higher risk; a lower cap rate indicates less. Cap rates also tend to have an inverse relationship to how much the property is worth. A more expensive property will have a lower cap rate, and a less expensive property will have a higher cap rate.

What factors impact capitalization rate?

Before leveraging cap rate to make decisions on investment opportunities, it’s important to understand the factors that affect the rate. Failing to do so could result in a bad—and costly — business decision. Here are the three major factors that impact capitalization rate.

1. Property type

There are six different property types: agricultural, residential, commercial, industrial, mixed-use, and special purpose, which are then further divided by property characteristics. Commercial real estate, for instance, includes office spaces, shopping centers, and hotels, among others. The type of property determines the risk, expenses, and potential return, all of which inform the cap rate.

2. Property value

Real estate investments have different cap rates depending on how they fit into the market as a whole. On a national scale, real estate in cities tends to have higher cap rates than similar properties in smaller cities or towns. Economies in urban areas are diverse, vibrant, and tend to be more stable, so these investment opportunities are perceived as less risky than their rural counterparts.

Picture an apartment building in a big city: This complex would cost a pretty penny, but big cities draw prospective tenants, so the potential returns would be higher. With less risk, one would expect a lower cap rate than if it were located in a more lightly trafficked part of the state.

On a more local level, cap rates also depend largely on comparative properties within the area. Properties of a town or city are divided into classes—A, B, and C. Investors, lenders, and brokers have developed the class system to more effectively and efficiently communicate the quality of a property. Class A buildings are considered the highest quality based on their location and condition. Because they are valued higher, Class A properties have a lower cap rate.

3. Rental potential

A property’s features and condition do not only inform its overall value but also how desirable those features are to prospective tenants. Without tenants, an investment property will bring in little to no income, which could make it more of a financial burden than a revenue stream.

Along with features and condition, rental potential comprises several factors, including supply and demand of real estate in the area and the strength of the rental agreement. All of these moving parts feed into the leasing potential of a property and therefore the cap rate.

Final Thoughts

Capitalization rates can help you gauge the potential of a property investment, but they offer a limited scope by only taking two elements into account: the property’s net operating income and current market value. At the end of the day, cap rates are based on estimates, not guarantees. When applying this rate to your own life, you should view it as guidance for how, when, and where to invest in real estate, rather than a promise for financial success.

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