"What is Capitalization Rate"
"What is Capitalization Rate"
What is a 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.
Importance of Capitalization Rate
The capitalization rate is used to compare between different investment opportunities. For example, if all else equal, a property with a 10% cap rate versus another property’s 3%, an investor is most likely to focus on the property with a 10% cap rate.
The rate also indicates the amount of time it takes to recover an investment in a property. For example, if a property comes with a 10% cap, it will take 10 years for the investor to recover his investment (called “fully capitalized”).
Although it’s an important metric in comparing investment opportunities, investors should never base a purchase on the cap rate of a property alone. It is useful to note that different cap rates represent different levels of risk – a low cap implies lower risk while a high cap implies higher risk. Therefore, there is no “optimal” cap rate – it depends on the investor’s risk preference
For example, consider two properties in different geographical locations – one is in a highly coveted suburban region while the other is in a run-down part of the city. The property in the highly coveted suburban region would show a lower cap through the high market value of the asset. On the contrary, the property located in the run-down part of the city would come with a higher cap, reflected by the lower market value of that asset.
What is a Good Cap Rate?
What’s a good cap rate? The short answer is that it depends on how you are using the cap rate. For example, if you are selling a property then a lower cap rate is good because it means the value of your property will be higher. On the other hand, if you are buying a property then a higher cap rate is good because it means your initial investment will be lower.
You might also be trying to find a market-based cap rate using recent sales of comparable properties. In this case, a good cap rate is one that is derived from similar properties in the same location. For example, suppose you want to figure out what an office building is worth based on a market-derived cap rate. In this case, a good cap rate is one that is derived from recent office building sales in the same market. A bad cap rate would be one derived from different property types in different markets.
When, and When Not, to Use a Cap Rate
The cap rate is a very common and useful ratio in the commercial real estate industry and it can be helpful in several scenarios. For example, it can and often is used to quickly size up an acquisition relative to other potential investment properties. A 5% cap rate acquisition versus a 10% cap rate acquisition for a similar property in a similar location should immediately tell you that one property has a higher risk premium than the other.
Another way cap rates can be helpful is when they form a trend. If you’re looking at cap rate trends over the past few years in a particular sub-market then the trend can give you an indication of where that market is headed. For instance, if cap rates are compressing that means values are being bid up and a market is heating up. Where are values likely to go next year? Looking at historical cap rate data can quickly give you insight into the direction of valuations.
While cap rates are useful for quick back of the envelope calculations, it is important to note when cap rates should not be used. When properly applied to a stabilized Net Operating Income (NOI) projection, the simple cap rate can produce a valuation approximately equal to what could be generated using a more complex discounted cash flow (DCF) analysis. However, if the property’s net operating income stream is complex and irregular, with substantial variations in cash flow, only a full discounted cash flow analysis will yield a credible and reliable valuation.
Bottom Line
- The capitalization rate is a profitability metric used to determine the return on investment of a real estate property.
- The formula for the capitalization rate is calculated as net operating income divided by the current market value of the asset.
- The capitalization rate can be used to determine the riskiness of an investment opportunity – a high capitalization rate implies lower risk while a low capitalization rate implies higher risk.
- The capitalization rate should be used in conjunction with other metrics and investors should never base a purchase on the capitalization rate of a property alone.