What is the 'Capitalization Rate'
The capitalization rate is the rate of return on a real estate investment property based on the income that the property is expected to generate. The capitalization rate is used to estimate the investor's potential return on his or her investment.
The capitalization rate of an investment may be calculated by dividing the investment’s net operating income (NOI) by the current market value of the property, where NOI is the annual return on the property minus all operating costs. The formula for calculating the capitalization rate can be expressed in the following way:
Capitalization Rate = Net Operating Income / Current Market Value
Some consider the capitalization rate to be, in essence, the discount rate of a perpetuity, though the use of perpetuity in this case may be slightly misleading as it implies cash flows will be steady on an annual basis.
The capitalization rate is expressed as a percentage and is also often known as the “cap rate.”
BREAKING DOWN 'Capitalization Rate'
The capitalization rate is very useful in that it streamlines information about real estate investments and makes it easy to interpret. For example, if Stephan buys a property for $900,000 and expects that the property will generate $125,000 per year after operating costs, the capitalization rate for his investment is 13.89% ($125,000 / $900,000 = 0.1389 = 13.89%). What this means is that, every year, Stephan is earning 13.89% of the value of his property as profit.
This example assumes that all factors of Stephan’s cap rate calculations will remain constant, but in reality things often get a little more complicated. Suppose that due to a boom in demand for real estate in Stephan’s town after he makes the investment, the value of Stephan’s property rises to $2 million by the time two years has passed. Meanwhile, Stephan has been making the same amount of money from the property. Since capitalization rate calculations use the current market value, the capitalization rate of Stephan’s investment has changed. Because the market value of the property has risen while Stephan’s NOI has not, the cap rate has dropped considerably to a less favorable 6.25% ($125,000 / $2 million = 0.0625 = 6.25%).
Examples like this illustrate an important function of capitalization rates. Because the cap rate is a ratio gauging profitability, the proportion of NOI relative to the current market value must remain constant in order for the capitalization rate to remain the same. If NOI rises while the market value does not, the capitalization rate will rise and, if the opposite happens, the capitalization rate will decline. In order for a real estate investment to remain profitable, NOI needs to increase at the same rate as the property value increases, or at an even greater rate. In this respect, capitalization rate is useful because it can be used to track a real estate investment over time to see whether or not its performance is improving. If, for whatever reason, the capitalization rate is declining, it may be a wiser decision to simply sell the property and reinvest elsewhere. With a drop of over 50% in Stephan’s cap rate in just two years, he would likely be best off either finding a way to raise his NOI or selling the property and finding an alternative investment.
Uses of Capitalization Rate
Often, comparing different property investments can be like comparing apples and oranges, so the capitalization rate is a good jumping-off point because it can be used to quickly and easily compare many investment opportunities with one another. Comparing the market values or operating income estimates of various properties will often be difficult and yield results that are difficult to sift through, but comparing percentages is very straightforward.
For example, suppose Martha is considering two different investments with market values of $230,000 and $3M and estimates that their NOI values will be $40,000 and $300,000, respectively. While these investments differ substantially, knowing that their respective capitalization rates are 17.39% and 10% may help Martha make her decision. Yet, while the first investment’s cap rate is much higher, the second investment will earn much more money annually, so this will likely play into Martha’s decision as well. While this example helps illustrate cap rate’s ability to help in comparing investments, it is important to note that it is most useful in this function when either the NOI or current market value are comparable. Investments of drastically different sizes may often have additional considerations that can prevent smooth comparisons.
When seeking to invest in real estate, investors will often decide on the lowest cap rate that they will accept in order to make the investment worth their while. For example, an investor might decide that, for the amount of money they are looking to spend, they will only accept an investment with a capitalization rate of 10% or higher. When looking at potential investments, then, they will compare the cap rates of those investments against their personal cap rate.
The capitalization rate may also be used to roughly calculate the payback period of the investment by dividing 100 by the cap rate when expressed as a whole number. For example, one can calculate the payback period of an investment with a cap rate of 5% by dividing 100 by 5, for an estimated payback period of 20 years. Yet, this method should only be used to get a rough estimate of the investment’s payback period because few real estate investments will retain a constant capitalization rate over a long period of time.
Additionally, direct capitalization is a method used for valuing a real estate investment that incorporates the capitalization rate. With this method, one can divide NOI by the cap rate in order to determine the investment’s capital cost. Though this may sound complicated, it is essentially a reconfiguration of the cap rate formula.
Issues with Capitalization Rate
While the capitalization rate is a very useful ratio to use when planning or analyzing an investment, it comes with a few important limitations that should be considered before using the cap rate.
One such limitation is that the cap rate is not very useful for short-term investments. With little time to develop a reliable cash flow, an investment’s NOI can be difficult or impossible to determine, thereby making cap rate calculations difficult or impossible as well.
It is also important to note that the capitalization rate is sometimes calculated as NOI divided by the original amount the current owner paid for the property. Because the value of a property will rarely remain the same for very long, this method of calculating cap rates is far less useful than the other method. Calculating a cap rate for a property with a value of $2 million in 2015 based on its 1995 price of $300,000 will not be very useful and will give very misleading results. Additional issues when using this method may also arise in the case of a property given as a gift or through inheritance, as the cap rate cannot be determined with a cost of zero.
The capitalization rate is a popular and easy ratio to use, but it should not be the sole factor in any real estate investment decision. Many more factors need to be looked at such as the growth or decline of the potential income, the increase in value of the property and any alternative investments available.