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Capitalization Rate, more commonly referred to as Cap Rate, is the rate of return on a real estate investment based on the income the property is expected to generate. In other words, the Capitalization Rate is used to estimate an investor’s likely return on investment in a property if the property is purchased with cash. Capitalization Rate is used commonly to compare potential real estate investments and may also be used to compare potential businesses for sale.
Calculating Cap Rate
The Capitalization Rate is calculated by dividing the investment’s net operating income (NOI) by the current market value of the property (or alternatively, the original capital cost). NOI is defined as the annual return on the property minus all operating costs.
Capitalization Rate = Net Operating Income / Current Market Value
The Capitalization Rate is expressed as a percentage.
How to Apply the Cap Rate
Compare investments – By comparing Capitalization Rates, an investor can quickly determine which properties would provide a higher return, and therefore have a higher risk premium. For example, if one property has a Cap Rate of 10% while another similar property in a comparable location has a Cap Rate of 5%, we know that the property with a Cap Rate of 10% comes with more risk, and offers a higher potential return on investment. Alternatively, the property with a cap rate of 5% presents less risk, but also a smaller potential return on investment.
Evaluate Trends – When Capitalization Rates form a trend, they can offer an indication of where the real estate market is headed. Look at trends for comparable markets and properties over a period of a few years, particularly in a sub-market, to identify trends. If Cap Rates seem to be compressing, investors can assume that values are being bid up. Evaluating historical Cap Rate data offers insight into the future direction of property valuations.
The Cap Rate Can Be Deceiving
Keep in mind that while the Capitalization Rate can be an incredibly useful tool for predicting market trends and evaluating property investments, there are limitations to its use. First, when using the Cap Rate to compare the potential return on investment for multiple properties, it is critical to keep in mind that the properties should be similar. A number of factors can affect a property’s potential return on investment – including location, size, age, tenants, and economic fundamentals of the region (population growth, employment growth, etc.). As such, a certain amount of the Cap Rate is subjective.
Additionally, if a property has a complex or irregular net operating income stream, only a full discounted cash flow (DCF) analysis will result in a reliable valuation.
The Capitalization Rate is also not very useful for short term investments. Because short term investments often don’t have enough time to develop reliable cash flows, the investment’s NOI can be hard to determine, making a Cap Rate calculation difficult and unreliable.
Some Capitalization Rates are calculated by dividing the NOI by the original amount the current owner paid for the property. But because market values can fluctuate significantly over time, only using the most current market value will result in a reliable Cap Rate.
Despite these shortcomings, the Capitalization Rate remains a simple and popular valuation tool for real estate investors. Yet by weighing in a number of external factors – including the growth or decline of the property’s value, alternative investments, and market trends – investors can feel confident about using the Cap Rate in their analysis.