1/4/2020 Capitalization Rate Definition

ALTERNATIVE INVESTMENTS REAL ESTATE INVESTING

Capitalization Rate
By JAMES CHEN | Updated Oct 13, 2019

What Is 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.

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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.

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KEY TAKEAWAYS
Capitalization rate is calculated by dividing a property's net operating income by the
current market value.
This ratio, expressed as a percentage, is an estimation for an investor's potential return
on a real estate investment.
Cap rate is most useful as a comparison of relative value of similar real estate
investments.

Understanding Capitalization Rate

Cap rate is the most popular measure through which real estate investments are assessed for
their profitability and return potential. The cap rate simply represents the yield of a property
over a one year time horizon assuming the property is purchased on cash and not on loan. The
capitalization rate indicates the property’s intrinsic, natural, and un-leveraged rate of return.

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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

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where,

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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.

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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.

Examples of Capitalization Rate

Assume that an investor has $1 million and he is considering investing in one of the two
available investment options – one, he can invest in government-issued treasury bonds that
offer a nominal 3 percent annual interest and are considered the safest investments and two, he
can purchase a commercial building that has multiple tenants who are expected to pay regular
rent.

In the second case, assume that the total rent received per year is $90,000 and the investor
needs to pay a total of $20,000 towards various maintenance costs and property taxes. It leaves
the net income from the property investment at $70,000. Assume that during the first year, the
property value remains steady at the original buy price of $1 million.

The capitalization rate will be computed as (Net Operating Income/Property Value) = $70,000/$1
million = 7%.

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This return of 7 percent generated from the property investment fares better than the standard
return of 3 percent available from the risk-free treasury bonds. The extra 4 percent represents
the return for the risk taken by the investor by investing in the property market as against
investing in the safest treasury bonds which come with zero risk.

Property investment is risky, and there can be several scenarios where the return, as
represented by the capitalization rate measure, can vary widely.

For instance, a few of the tenants may move out and the rental income from the property may
diminish to $40,000. Reducing the $20,000 towards various maintenance costs and property
taxes, and assuming that property value stays at $1 million, the capitalization rate comes to
($20,000 / $1 million) = 2%. This value is less than the return available from risk-free bonds.

In another scenario, assume that the rental income stays at the original $90,000, but the
maintenance cost and/or the property tax increases significantly, to say $50,000. The
capitalization rate will then be ($40,000/$1 million) = 4%.

In another case, if the current market value of the property itself diminishes, to say $800,000,
with the rental income and various costs remaining the same, the capitalization rate will
increase to $70,000/$800,000 = 8.75%.

In essence, varying levels of income that gets generated from the property, expenses related to
the property and the current market valuation of the property can significantly change the
capitalization rate.

The surplus return, which is theoretically available to property investors over and above the
treasury bond investments, can be attributed to the associated risks that lead to the above-
mentioned scenarios. The risk factors include:

Age, location, and status of the property

Property type – multifamily, office, industrial, retail or recreational
Tenants’ solvency and regular receipts of rentals
Term and structure of tenant lease(s)
The overall market rate of the property and the factors affecting its valuation
Macroeconomic fundamentals of the region as well as factors impacting tenants’ businesses

Interpreting the Capitalization Rate

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Since cap rates are based on the projected estimates of the future income, they are subject to
high variance. It then becomes important to understand what constitutes a good cap rate for an
investment property.

The rate also indicates the duration of time it will take to recover the invested amount in a
property. For instance, a property having a cap rate of 10% will take around 10 years for
recovering the investment.

Different cap rates among different properties, or different cap rates across different time
horizons on the same property, represent different levels of risk. A look at the formula indicates
that the cap rate value will be higher for properties that generate higher net operating income
and have a lower valuation, and vice versa.

Say, there are two properties that are similar in all attributes except for being geographically
apart. One is in a posh city center area while the other is on the outskirts of the city. All things
being equal, the first property will generate a higher rental compared to the second one, but
those will be partially offset by the higher cost of maintenance and higher taxes. The city center
property will have a relatively lower cap rate compared to the second one owing to its
significantly high market value.

It indicates that a lower value of cap rate corresponds to better valuation and a better prospect
of returns with a lower level of risk. On the other hand, a higher value of cap rate implies
relatively lower prospects of return on property investment, and hence a higher level of risk.

While the above hypothetical example makes it an easy choice for an investor to go with the
property in the city center, real-world scenarios may not be that straightforward. The investor
assessing a property on the basis of cap rate faces the challenging task to determine the
suitable cap rate for a given level of the risk.

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Capitalization Rate

Gordon Model Representation for Cap Rate

Another representation of the cap rate comes from the Gordon Growth Model, which is also
called as the dividend discount model (DDM). It is a method for calculating the intrinsic value of
a company’s stock price independent of the current market conditions, and the stock value is
calculated as the present value of a stock's future dividends. Mathematically,

Stock Value = Expected Annual Dividend Cash Flow / (Investor's Required Rate of Return -
Expected Dividend Growth Rate)

Rearranging the equation and generalizing the formula beyond dividend,

(Required Rate of Return - Expected Growth Rate) = Expected Cash Flow / Asset Value

The above representation matches the basic formula of capitalization rate mentioned in the
earlier section. The expected cash flow value represents the net operating income and the asset
value matches with the current market price of the property. This leads to the capitalization rate
being equivalent to the difference between the required rate of return and the expected growth
rate. That is, the cap rate is simply the required rate of return minus the growth rate.

This can be used to assess the valuation of a property for a given rate of return expected by the
investor. For instance, say the net operating income of a property is $50,000, and it is expected
to rise by 2 percent annually. If the investor’s expected rate of return is 10 percent per annum,
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then the net cap rate will come to (10% - 2%) = 8%. Using it in the above formula, the asset
valuation comes to ($50,000 / 8%) = $625,000.

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Related Terms
Terminal Capitalization Rate: What You Need to Know
The terminal capitalization rate is the rate used to estimate the resale value of a property at the end of the
holding period. more

How to Use the Income Approach to Value Real Estate

The income approach is a real estate appraisal method that allows investors to estimate the value of a
property based on the income it generates. more

What Does the Operating Expense Ratio Measure?

The operating expense ratio (OER) is defined as a measurement of the cost to operate a piece of property
compared to the income brought in by the property. more

Net Operating Income: What You Need to Know

Net operating income (NOI) is a company's income after operating expenses are deducted, but before
deducting income taxes and interest. more

Dividend Discount Model – DDM

The dividend discount model (DDM) is a system for evaluating a stock by using predicted dividends and
discounting them back to present value. more

How the Mortgage Constant Is Used by Lenders and Real Estate

Investors
A mortgage constant is the percentage of money paid each year to pay or service a debt given the total
value of the loan. more

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