CAPITALIZATION RATE Capitalization rate (or "cap rate") is a measure of the ratio between the net operating income

produced by an asset (usually real estate) and its capital cost (the original price paid to buy the asset) or alternatively its current market value. The rate is calculated in a simple fashion as follows:

annual net operating income / cost (or value) = Capitalization Rate

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. 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.

Use for valuation

In real estate investment, real property is often valued according to projected capitalization rates used as investment criteria. This is done by algebraic manipulation of the formula above:

Capital Cost (asset price) = Cash flow / Capitalization Rate

For example, in valuing the projected sale price of an apartment building that produces an annual net cash flow of $10,000, if we set a projected capitalization rate at 7%, then the asset value (or price we would pay to own it) is $142,857. This is often referred to as direct capitalization, and is commonly used for valuing income generating property in a real estate appraisal. One advantage of capitalization rate valuation is that it is separate from a "marketcomparables" approach to an appraisal (which compares 3 valuations: what other similar properties have sold for based on a comparison of physical, location and economic characteristics, actual replacement cost to re-build the structure in addition to the cost of the land and capitalization rates). Given the inefficiency of real estate markets, multiple approaches are generally preferred when valuing a real estate asset. Capitalization rates for similar properties, and particularly for "pure" income

properties, are usually compared to ensure that estimated revenue is being properly valued.

[edit] Cash flow defined

The capitalization rate is calculated using a measure of cash flow called net operating income (NOI), not net income. Generally, NOI is defined as income (earnings) before depreciation and interest expenses:

Cash flow = Net income + depreciation + interest expense + profit tax reserves for repairs = Gross income - non-interest expenses

Interest expenses are excluded so that the valuation of the property does not depend on the amount of debt used to purchase the property; in financial terms, the cap rate is a capital structure-neutral valuation measure. Similarly, profit taxes (or other similar taxes) are usually excluded, as they will depend on the interest and depreciation expenses charged; most other taxes, and specifically property taxes, are treated as part of non-interest expenses. Depreciation in the tax and accounting sense is excluded from the valuation of the asset, because it does not directly affect the cash generated by the asset. To arrive at a more careful and realistic definition, however, estimated annual maintenance expenses or capital expenditures will be included in the non-interest expenses. Although cash flow is the generally-accepted figure used for calculating cap rates, this is often referred to under various terms, including simply income.

[edit] Use for comparison

Capitalization rates, or cap rates, provide a tool for investors to use for roughly valuing a property based on its income. For example, if a real estate investment provides $160,000 a year in cash flow and similar properties have sold based on 8% cap rates, the subject property can be roughly valued at $2,000,000 because $160,000 divided by 8% (0.08) equals $2,000,000. [edit] ReProperty values based on capitalization rates are calculated on an "in-place" or "passing rent" basis, i.e. given the rental income generated from current tenancy agreements. In addition, a valuer also provides an Estimated Rental Value (ERV). The ERV states the valuers opinion as to the open market rent which could reasonably be expected to be achieved on the subject property at the time of valuation. The difference between the in-place rent and the ERV is the reversionary value of the property. For example, with passing rent of $160,000, and an ERV of $200,000, the property is $40,000 reversionary. Holding the valuers cap rate constant at 8%, we could consider the property as having a current value of $2,000,000 based on passing rent, or $2,500,000 based on ERV. Finally, if the passing rent payable on a property is equivalent to its ERV, it is said to be "Rack Rented".

[edit] Change in asset value

The cap rate only recognizes the cash flow a real estate investment produces and not the change in value of the property. To get the unlevered rate of return on an investment the real estate investor adds (or subtracts) the price change percentage from the cap rate. For example, a property delivering an 8% capitalization, or cap rate, that increases in value by 2% delivers a 10% overall rate of return. The actual realised rate of return will depend on the amount of borrowed funds, or leverage, used to purchase the asset. In Europe, the term Yield is more frequently used in connection with real estate than capitalization rate. Yield is a more general term that refers to income in relation to the price of an asset. http://www.invest-2win.com/caprate.html Cap Rate - Capitalization Rate

The Capitalization Rate or Cap Rate is a ratio used to estimate the value of income producing properties. Put simply, the cap rate is the net operating income divided by the sales price or value of a property expressed as a percentage. Investors, lenders and appraisers use the cap rate to estimate the purchase price for different types of income producing properties. A market cap rate is determined by evaluating the financial data of similar properties which have recently sold in a specific market. It provides a more reliable estimate of value than a market Gross Rent Multiplier since the cap rate calculation utilizes more of a property's financial detail. The GRM calculation only considers a property's selling price and gross rents. The Cap Rate calculation incorporates a property's selling price, gross rents, non rental income, vacancy amount and operating expenses thus providing a more reliable estimate of value. If we have a seller and an interested buyer for particular piece of income property, the seller is trying to get the highest price for the property or sell at the lowest cap rate possible. The buyer is trying to purchase the property at the lowest price possible which translates into a higher cap rate. The lower the selling price the higher the cap rate. The higher the selling price, the lower the cap rate. In summary, from an investor's or buyer's perspective, the higher the cap rate, the better. Investors expect a larger return when investing in high risk income properties. The Cap rate may vary in different areas of a city for many reasons such as desirability of location, level of crime and general condition of an area. You would expect lower capitalization rates in newer or more desirable areas of a city and higher cap rates in less desirable areas to compensate for the added risk. In a real estate market where net operating incomes are increasing and cap rates are declining over time for a given type of investment property such as office buildings, values will be generally increasing. If net operating incomes are decreasing and capitalization rates are increasing over time in a given market place, property values will be declining. If you would like to find out what the cap rate is for a particular type of property in a given market place, check with an appraiser or lender in that area. Be aware that the frequency of sales for commercial income properties in a given market place may be low and reliable capitalization rate data may not be available. If you are able to obtain a market cap rate from an appraiser or lender for the type of property you are evaluating, check to see if the cap rate value was determined with recent sales of comparable properties or if it was constructed. When adequate financial data is unavailable, appraisers may construct a cap rate through analysis of its component parts thus reducing the

credibility of the results. Cap rates which are determined by evaluating the recent actions of buyers and sellers in a particular market place will produce the best market value estimate for a property. On Target 3.01 - Real Estate Investment Software Just $97.95
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If you are able to obtain a market cap rate, you can then use this information to estimate what similar income properties should sell for. This will help you to gauge whether or not the asking price for a particular piece of property is over or under priced.
Cap Rate = NOI -----------------Market Value Estimated Market Value = NOI -------------Cap Rate

Example 1: A property has a NOI of $126,000 and the asking price is $1,200,000.
$126,000 Cap Rate = -------------$1,200,000 X 100 = 10.5

Example 2: A property has a NOI of $120,000 and Cap Rates in the area for this type of property average about 10.
Estimated Market Value = $120,000 -------------.10 = $1,200,000

Net operating income is determined by subtracting vacancy amount and operating expenses from a property's gross income. Operating expenses include the following items: advertising, insurance, maintenance, property taxes, property management, repairs, supplies, utilities, etc. Operating expenses do not include the following items; Improvements such as a new roof, personal property such as a lawn mower, mortgage payments, income and capital gains taxes, loan origination fees, etc. Appraisers use the Income Approach, Cost Replacement and Market Comparison methods to estimate the value of property. The Income Approach utilizes the theory of Capitalization. The On Target Real Estate Investment Software calculates the Cap Rate for an income producing property as you enter the property data. You can run "what if" scenarios changing the sales price, rental income, vacancy rate and operating expense amounts and the cap rate is automatically recalculated. No need to use a calculator to run different scenarios. The ratio analysis report summarizes the cap rate data over a ten year period based on your input data and assumptions.