What is a Cap Rate and How is it Utilized?
Capitalization rate is the rate of return on a real estate investment property based on the income the property is expected to generate. The capitalization rate is used to estimate the investor’s potential return on their investment without debt.
The capitalization rate of an investment may be calculated by dividing the investment’s net operating income (NOI) by the current market value of the property, where NOI is the annual return on the property less all operating costs. The formula for calculating the capitalization rate can be expressed in the following way:
Net Operating Income / Current Market Value = Capitalization Rate
The capitalization rate is expressed as a percentage and is also often known as the “cap rate.”
Breaking Down the Capitalization Rate (Example)
The capitalization rate streamlines information about real estate investment and makes it easy to interpret. For example, a property is purchased for $900,000 and the investor expects the property will generate $125,000 per year after operating costs; the capitalization rate for his investment is 13.89% ($125,000 / $900,000 = 0.1389 = 13.89%). What this means is that, every year the investor is earning 13.89% of the value of his property as profit.
The cap rate is a ratio gauging the investors return, the proportion of NOI relative to the current market value must remain constant in order 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. In order for a real estate investment to remain profitable, NOI needs to increase at the same rate as the property value increases, or at an even greater rate. In this respect, capitalization rate is useful because it can be used to track a real estate investment over time to see whether or not 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. With a drop of over 50% in the example above, the investor would likely be best off either finding a way to raise his NOI or selling the property and finding an alternative investment.
Uses of Capitalization Rate
Often, comparing different property investments can be like comparing apples and oranges, so the capitalization rate is a good jumping-off point because it can be used to quickly and easily compare many investment opportunities with one another. Comparing the market values or operating income estimates of various properties will often be difficult and yield results that are difficult to sift through, but comparing percentages is very straightforward.
When seeking to invest in real estate, investors will often decide on the lowest cap rate that they will accept in order to make the investment worth their while. For example, an investor might decide that, for the amount of money they are looking to spend, they will only accept an investment with a capitalization rate of 6% or higher. When looking at potential investments, then, they will compare the cap rates of those investments against their personal cap rate.
The capitalization rate may also be used to roughly calculate the payback period of the investment by dividing 100 by the cap rate when expressed as a whole number. For example, one can calculate the payback period of an investment with a cap rate of 5% by dividing 100 by 5, for an estimated payback period of 20 years. Yet, this method should only be used to get a rough estimate of the investment’s payback period because few real estate investments will retain a constant capitalization rate over a long period of time.
Additionally, direct capitalization is a method used for valuing a real estate investment that incorporates the capitalization rate. With this method, one can divide NOI by the cap rate in order to determine the investment’s capital cost and the value of the investment. Though this may sound complicated, it is essentially a reconfiguration of the cap rate formula.
Concerns About Using the Capitalization Rate
The capitalization rate is a very useful ratio it comes with a few important limitations that should be considered before using the cap rate.
The cap rate is not very useful for short-term investments. With little time to develop a reliable cash flow, an investment’s NOI can be difficult or impossible to determine, thereby making cap rate calculations difficult or impossible as well.
The cap rate is also not very useful for investments which have a limited expenses generated from an investment. For example, apartment complexes with 8 units or less do not generate enough operating expenses to properly calculate the value of the property or provide an accurate return.
The capitalization rate is a popular and easy ratio to use, but it should not be the sole factor in any real estate investment decision. Many more factors need to be looked at such as the growth or decline of the potential income, the increase in value of the property and any alternative investments available.