The capitalization 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. Often called the "cap rate," this measure is computed based on the net income which the property is expected to generate. It is used to estimate the investor's potential return on their investment in the real estate market.

BREAKING DOWN 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.

Capitalization Rate Formula

Several versions exist for the computation of the capitalization rate. In the most popular version, 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

where,

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. These expenses include the cost paid towards 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 inherited property as their purchase price is zero making the division impossible.

Additionally, since property prices fluctuate widely, the first version using 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%.

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)
  • 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

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 lower valuation, and vice versa.

Say, there are two properties which 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 a better valuation, and 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 of the difference between 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, 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.

The Bottom Line

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. A lot of factors determine the value of a property and the net returns from it, and investors must take a holistic approach in addition to considering such quantitative measures.