What Is the Capitalization Rate?

What Is the Capitalization Rate?

Let me explain the capitalization rate, or cap rate, which you'll encounter in commercial real estate as a way to gauge the expected rate of return on an investment property.

You calculate this by taking the net income the property should generate and dividing it by the property's asset value, then expressing it as a percentage. This gives you an estimate of what return you might see on your investment in the real estate market. It also comes into play when figuring the exit or terminal cap rate for when you sell the property after holding it for a while.

Sure, the cap rate lets you quickly compare similar real estate investments in the market, but don't rely on it alone to judge an investment's strength. It overlooks things like leverage, the time value of money, and cash flows from future improvements to the property.

Key Takeaways

You get the capitalization rate by dividing the property's net operating income by its current market value. This percentage estimates your potential return as an investor in real estate. It's especially handy for comparing the relative value of similar investments.

Understanding the Capitalization Rate

The cap rate stands out as the go-to measure for evaluating the profitability and return potential of real estate investments.

It basically shows the yield of a property over one year, assuming you buy it with cash rather than a loan. This rate reflects the property's inherent, natural, and unlevered return.

Formula for the Capitalization Rate

You'll find a few ways to compute the cap rate, but the most common one divides the property's net operating income (NOI) by its current market value. Mathematically, that's Capitalization Rate = Net Operating Income / Current Market Value.

Here, NOI is the expected annual income from things like rentals, minus expenses for upkeep and property taxes.

The current market value is what the property is worth today based on market rates. There's another version using the original purchase price: Capitalization Rate = Net Operating Income / Purchase Price.

But this second version isn't popular. It can give odd results for old properties bought cheaply years ago, and it doesn't work for inherited properties where the purchase price is zero. Plus, since property prices change, using the current market value provides a more accurate picture than sticking with the fixed original cost.

If you're looking to dive deeper into cap rates, consider checking out one of the top online real estate schools.

What the Capitalization Rate Can Tell You

Cap rates rely on projections of future income, so they can vary a lot. That's why you need to know what makes a good cap rate for a property.

The rate also shows how long it'll take to recover your investment. For example, a 10% cap rate means about 10 years to get your money back.

Different cap rates on properties or over time signal different risk levels. Higher cap rates come with higher NOI and lower valuations, and the opposite is true too.

No strict ranges exist for good or bad cap rates; it depends on the property and market context.

Imagine two similar properties, one in a fancy city center and one on the outskirts. The city one might pull higher rent but face steeper maintenance and taxes, leading to a lower cap rate due to its high market value.

This suggests a lower cap rate means better valuation and returns with less risk, while a higher one points to lower returns and more risk. But in real life, picking the right cap rate for your risk level can be tough.

Gordon Model Representation for Cap Rate

You can also see the cap rate through the Gordon Growth Model, or dividend discount model, which values stock based on future dividends.

The formula is Stock Value = Expected Annual Dividend Cash Flow / (Investor's Required Rate of Return - Expected Dividend Growth Rate). Rearranging it gives (Required Rate of Return - Expected Growth Rate) = Expected Cash Flow / Asset Value.

This matches the cap rate formula, where expected cash flow is NOI and asset value is market price. So, cap rate equals required return minus growth rate.

Use this to value a property. Say NOI is $50,000 with 2% annual growth, and you want 10% return. Cap rate is 8%, valuing the property at $625,000.

Limitations of the Cap Rate

Cap rate works well for stable income properties, but it's less reliable with irregular cash flows. In those cases, try a discounted cash flow model instead.

It assumes stable long-term income and ignores future risks like depreciation or rental market shifts. Factor those in when using cap rates.

What Is a Good Cap Rate?

No one ideal cap rate exists; it depends on your risk tolerance. Higher rates mean more risk, lower ones mean less risk but slower returns.

Analysts often see 5% to 10% as good, with 4% indicating low risk but a long recovery time. Consider local market features and don't rely on cap rate alone.

What Affects the Cap Rate?

Many market factors influence cap rates. Location is key, with high-traffic spots often yielding higher rates.

Look at competing properties too; big markets tend to have lower cap rates due to competition. Future trends like market growth can impact long-term rates.

Your capital investment matters as well. Renovations that boost appeal can raise rents and NOI, affecting the cap rate.

Examples of the Capitalization Rate

Suppose you have $1 million to invest: Treasury bonds at 3% or a commercial building with tenants.

For the building, say annual rent is $90,000, minus $20,000 in costs, leaving $70,000 NOI. If value stays at $1 million, cap rate is 7%. That's better than 3%, with the extra covering property market risk.

Property investing is risky, and cap rates can shift. If rent drops to $40,000, NOI becomes $20,000, cap rate 2%—worse than bonds.

Or if costs rise to $50,000, NOI is $40,000, cap rate 4%. If value falls to $800,000 with original NOI, cap rate rises to 8.75%.

These changes stem from income variations, expenses, and market value. The premium over bonds covers risks like property age, type, tenant solvency, leases, market rates, and regional economics.

What Should My Capitalization Rate Be?

Aim for 4% to 10% on an investment property, depending on location and your required return.

Is a Higher or Lower Capitalization Rate Better?

Cap rate measures risk, so higher means more risk, lower means less. It depends on your profile.

What Is the Difference Between the Capitalization Rate and the Return on Investment?

ROI shows potential return over time; cap rate shows current or expected return.

The Bottom Line

You use cap rate to assess commercial rental property profitability. High rates mean high income relative to investment, but consider risk and market factors too. Look at multiple metrics beyond just cap rate.