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) = apitali!ation "ate

#or e$ample% if a building is purchased for &'%(((%((( sale price and it produces &'((%((( in positive net operating income (the amount left over after fi$ed costs and variable costs are subtracted from gross lease income) during one year% then:

&'((%((( / &'%(((%((( = (.'( = '()

The asset*s capitali!ation rate is ten percent. apitali!ation rates are an indirect measure of how fast an investment will pay for itself. +n the e$ample above% the purchased building will be fully capitali!ed (pay for itself) after ten years ('(() divided by '()). +f the capitali!ation rate were ,)% the payback period would be twenty years. -ote that a real estate appraisal in the ../. uses net operating income. ash flow e0uals net operating income minus debt service. 1here sufficiently detailed information is not available% the capitali!ation rate will be derived or estimated from net operating income to determine cost% value or re0uired annual income.

Use for valuation

+n real estate investment% real property is often valued according to pro2ected capitali!ation rates used as investment criteria. This is done by algebraic manipulation of the formula above:

apital ost (asset price) = ash flow / apitali!ation "ate

#or e$ample% in valuing the pro2ected sale price of an apartment building that produces an annual net cash flow of &'(%(((% if we set a pro2ected capitali!ation rate at 3)% then the asset value (or price we would pay to own it) is &'45%6,3. This is often referred to as direct capitali!ation% and is commonly used for valuing income generating property in a real estate appraisal. 7ne advantage of capitali!ation rate valuation is that it is separate from a "market8 comparables" approach to an appraisal (which compares 9 valuations: what other similar properties have sold for based on a comparison of physical% location and economic characteristics% actual replacement cost to re8build the structure in addition to the cost of the land and capitali!ation rates). :iven the inefficiency of real estate markets% multiple approaches are generally preferred when valuing a real estate asset. apitali!ation rates for similar properties% and particularly for "pure" income

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

[edit] Cash flo defined

The capitali!ation rate is calculated using a measure of cash flow called net operating income (-7+)% not net income. :enerally% -7+ is defined as income (earnings) before depreciation and interest e$penses:

ash flow = -et income ; depreciation ; interest e$pense ; profit ta$ 8 reserves for repairs = :ross income 8 non8interest e$penses

+nterest e$penses are e$cluded 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 structure8neutral valuation measure. /imilarly% profit ta$es (or other similar ta$es) are usually e$cluded% as they will depend on the interest and depreciation e$penses charged< most other ta$es% and specifically property ta$es% are treated as part of non8interest e$penses. =epreciation in the ta$ and accounting sense is e$cluded from the valuation of the asset% because it does not directly affect the cash generated by the asset. To arrive at a more careful and realistic definition% however% estimated annual maintenance e$penses or capital e$penditures will be included in the non8interest e$penses. >lthough cash flow is the generally8accepted figure used for calculating cap rates% this is often referred to under various terms% including simply income.

[edit] Use for !o"parison

apitali!ation rates% or cap rates% provide a tool for investors to use for roughly valuing a property based on its income. #or e$ample% if a real estate investment provides &'?(%((( a year in cash flow and similar properties have sold based on 6) cap rates% the sub2ect property can be roughly valued at &5%(((%((( because &'?(%((( divided by 6) ((.(6) e0uals &5%(((%(((. @editA "eBroperty values based on capitali!ation rates are calculated on an "in8place" or "passing rent" basis% i.e. given the rental income generated from current tenancy agreements. +n addition% a valuer also provides an Cstimated "ental Dalue (C"D). The C"D states the valuerEs opinion as to the open market rent which could reasonably be e$pected to be achieved on the sub2ect property at the time of valuation. The difference between the in8place rent and the C"D is the reversionary value of the property. #or e$ample% with passing rent of &'?(%(((% and an C"D of &5((%(((% the property is &4(%((( reversionary. Folding the valuers cap rate constant at 6)% we could consider the property as having a current value of &5%(((%((( based on passing rent% or &5%,((%((( based on C"D. #inally% if the passing rent payable on a property is e0uivalent to its C"D% it is said to be ""ack "ented".

[edit] Chan#e in asset value

The cap rate only recogni!es 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. #or e$ample% a property delivering an 6) capitali!ation% or cap rate% that increases in value by 5) delivers a '() 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. +n Curope% the term Gield is more fre0uently used in connection with real estate than capitali!ation rate. Gield is a more general term that refers to income in relation to the price of an asset. http://www.invest85win.com/caprate.html Cap Rate - Capitalization Rate

The apitali!ation "ate or ap "ate is a ratio used to estimate the value of income producing properties. But simply% the cap rate is the net operatin# in!o"e divided by the sales price or value of a property e$pressed as a percentage. +nvestors% lenders and appraisers use the cap rate to estimate the purchase price for different types of income producing properties. > market cap rate is determined by evaluating the financial data of similar properties which have recently sold in a specific market. +t provides a more reliable estimate of value than a market :ross "ent Hultiplier since the cap rate calculation utili!es more of a property*s financial detail. The :"H calculation only considers a property*s selling price and gross rents. The ap "ate calculation incorporates a property*s selling price% gross rents% non rental income% vacancy amount and operating e$penses thus providing a more reliable estimate of value. +f 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 su""ar%& fro" an investor's or (u%er's perspe!tive& the hi#her the !ap rate& the (etter. +nvestors e$pect a larger return when investing in high risk income properties. The ap rate may vary in different areas of a city for many reasons such as desirability of location% level of crime and general condition of an area. Gou would e$pect lower capitali!ation rates in newer or more desirable areas of a city and higher cap rates in less desirable areas to compensate for the added risk. +n 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. +f net operating incomes are decreasing and capitali!ation rates are increasing over time in a given market place% property values will be declining. +f 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. Ie aware that the fre0uency of sales for commercial income properties in a given market place may be low and reliable capitali!ation rate data may not be available. +f 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. 1hen ade0uate financial data is unavailable% appraisers may construct a cap rate through analysis of its component parts thus reducing the

credibility of the results. ap 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 !".!#
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+f 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 ****************** +ar,et -alue Esti"ated +ar,et -alue ) NOI ************** Cap Rate

C$ample ': > property has a -7+ of &'5?%((( and the asking price is &'%5((%(((.
./01&222 Cap Rate ) ************** ./&022&222 3 /22 ) /2$4

C$ample 5: > property has a -7+ of &'5(%((( and ap "ates in the area for this type of property average about '(.
Esti"ated +ar,et -alue ) ./02&222 ************** $/2 ) ./&022&222

-et operating income is determined by subtracting vacancy amount and operating e$penses from a property*s gross income. 7perating e$penses include the following items: advertising% insurance% maintenance% property ta$es% property management% repairs% supplies% utilities% etc. 7perating e$penses do not include the following items< +mprovements such as a new roof% personal property such as a lawn mower% mortgage payments% income and capital gains ta$es% loan origination fees% etc. >ppraisers use the +ncome >pproach% ost "eplacement and Harket omparison methods to estimate the value of property. The +ncome >pproach utili!es the theory of apitali!ation. The 7n Target "eal Cstate +nvestment /oftware calculates the ap "ate for an income producing property as you enter the property data. Gou can run "what if" scenarios changing the sales price% rental income% vacancy rate and operating e$pense amounts and the cap rate is automatically recalculated. -o need to use a calculator to run different scenarios. The ratio analysis report summari!es the cap rate data over a ten year period based on your input data and assumptions.