A Simple Guide to Capitalization Rates

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If you’re looking to purchase a property, it’s a smart idea to estimate the capitalization rate to get an idea of its potential return on investment, before you buy. Understanding the rate of return on real estate is fundamental to your success as an investor.

The capitalization rate can be defined as the rate of return that a real estate investment property brings in based on the income that the property is projected to generate. The capitalization rate is used to estimate the investor’s likely return on his or her investment. It is stated as a percentage, and is also commonly known as the “cap rate.” The formula for calculating the cap rate can be expressed as follows:

 

CAPITALIZATION RATE = NET OPERATING INCOME / CURRENT MARKET VALUE

You can figure out the cap rate of an investment by dividing the net operating income (NOI) by the present market value of the property, where NOI is the annual return on the property, not including all operating costs.

Cap Rate Example

 Let’s have a look at one example of how a cap rate is typically used. Say we are studying the recent sale of an office building with a steadied Net Operating Income (NOI) of $500,000, and a sale price of $8,500,000. In the commercial real estate industry, it is common to say that this property sold at a 5.8% cap rate. So, for instance, if a property were to be listed for $2,000,000 and generated an NOI of $200,000 then the cap rate would be $200,000/$2,000,000, or 20%.

 Elements of the Cap Rate

 What are the foundations of the cap rate and how can they be determined?  One way to think about the cap rate is that it’s a function of the risk-free rate of return plus some risk premium.  In finance, the risk-free rate is the possible rate of return on investment with no chance of financial loss.  Of course, all investments carry even a small amount of risk, in practice.

Imagine that the acquisition cap rate on the investment property is 5%. This means that the risk premium over the risk-free rate is 2%.  This 2% risk premium reflects all of the additional risk you assume over and above the risk-free treasuries, which takes into account factors such as:

  • The diversity of the inhabitants.
  • The length of existing tenant leases.
  • Age of the property.
  • The creditworthiness of the tenants.
  • Broader supply and demand basics in the market for this particular asset class.
  • The economic fundamentals of the region, such as employment growth, population growth, and inventory of similar space on the market.

When you take all of these items and break them down, it’s not difficult to see their relationship to the risk-free rate and the general cap rate. It’s also crucial to note that the actual percentages of each risk factor of a cap rate, and in the end the cap rate itself, are different from individual to individual and depend on your business judgement and experience.