What Is the Capitalization Rate?
The capitalization rate, often referred to as cap rate, is a key metric in commercial real estate that indicates the expected rate of return on a property investment. It’s calculated by dividing the property’s net operating income by its current market value, and then expressing the result as a percentage. This measure helps investors estimate their potential return, as well as determine the property’s exit or terminal capitalization rate at the point of sale.
While beneficial for comparing similar real estate investments, the cap rate shouldn’t be the sole indicator of an investment’s strength, as it doesn’t account for aspects like leverage, the time value of money, and future cash flows from property improvements.
Key Takeaways
- The capitalization rate is calculated by dividing a property’s net operating income by the current market value.
- This ratio, expressed as a percentage, estimates an investor’s potential return on a real estate investment.
- The cap rate is most useful as a comparison of the relative value of similar real estate investments.
Understanding the Capitalization Rate
The cap rate is a prime measure to assess real estate investments’ profitability and return potential over a one-year timeframe, under the assumption that the property is purchased outright without financing. It represents the property’s natural, un-leveraged rate of return.
Formula for the Capitalization Rate
The widely accepted formula for cap rate calculation is:
Capitalization Rate = Net Operating Income / Current Market Value
- Net Operating Income (NOI) is the annual income generated by the property after deducting all operational expenses and property taxes.
- Current Market Value is the property’s present-day value as per the prevailing market rates.
Alternatively, the cap rate can be calculated using the acquisition cost:
Capitalization Rate = Net Operating Income / Purchase Price
However, this method is less preferred since it may yield unrealistic values, especially for older or inherited properties.
Interpreting the Capitalization Rate
Cap rates, influenced by projected future income, can vary significantly and are thus indicative of the risk associated with an investment. For example, a property with a 10% cap rate would theoretically take about ten years to recoup the initial investment.
Differences in cap rates stem from variations in net operating income and property valuation. A lower cap rate often correlates with high-valued properties with consistent rental income, indicating lower risk, whereas a higher cap rate may imply higher returns at increased risk levels.
Gordon Model Representation for Cap Rate
The Gordon Growth Model, also known as the dividend discount model, is another way to conceptualize the cap rate. Reformulated, it aligns closely with the cap rate formula:
(Required Rate of Return - Expected Growth Rate) = Expected Cash Flow / Asset Value
This implies that the cap rate equals the required rate of return minus the growth rate, allowing assessing property valuations based on investor expectations.
Limitations of the Cap Rate
While useful for stable-income properties, the cap rate is less reliable for properties with irregular or inconsistent cash flows where a discounted cash flow model may be more appropriate. The cap rate doesn’t account for future risks like property depreciation or market changes, highlighting the need for careful risk assessment.
What Is a Good Cap Rate?
Ideal cap rates vary based on investor risk appetites. Generally, a range of 5% to 10% is considered favorable, but local market conditions and individual risk profiles play crucial roles.
What Affects the Cap Rate?
Multiple factors influence cap rates including location, market competition, and property-specific characteristics. High-traffic areas generally command higher cap rates due to greater income potential, while well-developed markets might exhibit lower cap rates due to competitive dynamics. Additionally, investments in property improvements can impact cap rates positively.
Examples of the Capitalization Rate
Assume John has $1 million and is contemplating two investment options: risk-free Treasury bonds at 3% annual return or a commercial building generating $70,000 net income annually. The cap rate calculation for the property is:
Cap Rate = $70,000 / $1,000,000 = 7%
This 7% return outperforms the 3% return from Treasury bonds, reflecting a premium for the investment risk inherent in the property market. Variations in property income or value significantly affect this rate, as demonstrated in different scenarios exploring income and expense changes, further stressing the importance of cap rate as a dynamic measure.
Bottom Line
The capitalization rate is pivotal in assessing commercial rental properties’ profitability. While it indicates potential income relative to investment size, investors must consider wider metrics, bearing in mind the implications of risk and market conditions.
Related Terms: rate of return, net operating income, market value, acquisition cost, real estate market, capitalization rate formula
References
- Fortune Builders. “What Is a Good Cap Rate and How to Calculate It”.
- NOLO. “Evaluation Cap Rate: Is That Residential Real Estate Property Worth It?”
