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What is the 'Capitalization Rate'

The capitalization rate, often referred to as the "cap rate", is a fundamental concept used in the world of commercial real estate. It is the rate of return on a real estate investment property based on the income that the property is expected to generate. This metric is used to estimate the investor's potential return on his or her investment.

The capitalization rate of an investment can be calculated by dividing the property's net operating income (NOI) by the current market value or acquisition cost of a property - expressed in the following formula:

Capitalization Rate = Net Operating Income / Current Market Value

BREAKING DOWN 'Capitalization Rate'

In the simplest of terms. the cap rate can be a useful tool when it comes to comparing similar real estate investment properties.  Let's say that Stephan wants to buy a investment property for $900,000 and expects that it will generate $125,000 per year after operating costs. The cap rate for this investment would be 13.89% ($125,000 / $900,000 = 0.1389 = 13.89%). As Stephan continues to search for the right investment property, he could now use this expected cap rate to gauge the possible return generated from any comparable properties in the same price range - with all expenses considered.  

The cap rate's real world applications are much more complicated as it is just one of many factors in accessing the return on commercial real-estate property. If we build upon Stephan's example, let us presume that he finds another property with the same net operating income as the first but with a cap rate of 7%. 

In the simpler world referenced above, you may base your purchase decision on the cap rate. Stephan should purchase his first option. However, what if that building with the higher cap rate is an older run down apartment building with high turnover and the lower cap rate proposition is a modern office building with long-term corporate leases. It makes sense that the office building would have the higher appraised value due to age, possible extra amenities and the make-up of its renters.

The first option comes with added risks such as vacancy rates and possible needed renovation and updates. With the first option, you are paying less with the opportunity of a higher return because of the added risk. Just as in the world of traditional securities, the difference in return - or cap rate - can highlight a risk premium. Stephan would have to address his risk tolerance, along with the cap rate, in making his decision. 

The cap rate is a good point of origin in evaluating commercial real estate, but it is just one of many factors.

Capitalization Rate Adjustments

The cap rate is a ratio that gauges profitability. The proportion of NOI relative to the current market value must remain constant 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.

For a real estate investment to remain profitable at a certain level, NOI needs to increase at the same rate as the property value increases, or at an even greater rate. In this respect, the capitalization rate can be beneficial in tracking a real estate investment over time to see if 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.

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