# Capitalization rate

Capitalization rate (or "cap rate") is a real estate valuation measure used to compare different real estate investments. Although there are many variations, the cap rate is generally calculated as the ratio between the annual rental income produced by a real estate asset to its current market value. Most variations depended on the definition of the annual rental income and whether it is gross or net of annual costs, and whether the annual rental income is the actual amount received (initial yields), or the potential rental income that could be received if the asset was optimally rented (ERV yield).

## Basic formula

The rate is calculated in a simple fashion as follows:

${\displaystyle {\mbox{Capitalization Rate}}={\frac {\mbox{annual net operating income}}{\mbox{current value}}}}$

Some investors may calculate the cap rate differently.

In instances where the purchase or market value is unknown, investors can determine the capitalization rate using a different equation based upon historical risk premiums, as follows:

${\displaystyle {\mbox{Capitalization Rate}}={\frac {{\mbox{risk free rate}}+{\mbox{historical real estate risk premium}}-{\mbox{expected net operating income growth rate}}}{1-{\frac {\mbox{annual capital expenditures}}{\mbox{net operating income}}}}}}$

## Explanatory examples

For example, if a building is purchased for $1,000,000 sale price and it produces$100,000 in positive net operating income (the amount left over after fixed costs and variable costs are subtracted from gross lease income) during one year, then:

• $100,000 /$1,000,000 = 0.10 = 10%

The asset's capitalization rate is ten percent; one-tenth of the building's cost is paid by the year's net proceeds.

If the owner bought the building twenty years ago for $200,000 that is now worth$400,000, his cap rate is

• $100,000 /$400,000 = 0.25 = 25%.

It's important for the investor must take into account the opportunity cost of keeping his money tied up in this investment. By keeping this building, he is losing the opportunity of investing $400,000 (by selling the building at its market value and investing the proceeds). This is why the current value of the investment, not the actual initial investment, should be used in the cap rate calculation. Thus, for the owner of the building who bought it twenty years ago for$200,000, the real cap rate is twenty-five percent, not fifty percent, and he has $400,000 invested, not$200,000.

As another example of why the current value should be used, consider the case of a building that is given away (as an inheritance or charitable gift). The new owner divides his annual net income by his initial cost, say,

• $100,000 (income)/ 0 (cost) = UNDEFINED Anybody who invests any amount of money at an undefined rate of return very quickly has an undefined percent return on his investment. From this, we see that as the value of an asset increases, the amount of income it produces should also increase (at the same rate), in order to maintain the cap rate. Capitalization rates are an indirect measure of how fast an investment will pay for itself. In the example above, the purchased building will be fully capitalized (pay for itself) after ten years (100% divided by 10%). If the capitalization rate were 5%, the payback period would be twenty years. Note that a real estate appraisal in the U.S. uses net operating income. Cash flow equals net operating income minus debt service. Where sufficiently detailed information is not available, the capitalization rate will be derived or estimated from net operating income to determine cost, value or required annual income. An investor views his money as a "capital asset". As such, he expects his money to produce more money. Taking into account risk and how much interest is available on investments in other assets, an investor arrives at a personal rate of return he expects from his money. This is the cap rate he expects. If an apartment building is offered to him for$100,000, and he expects to make at least 8 percent on his real estate investments, then he would multiply the $100,000 investment by 8% and determine that if the apartments will generate$8000, or more, a year, after operating expenses, then the apartment building is a viable investment to pursue.

## Use for valuation

In real estate investment, real property is often valued according to projected capitalization rates used as investment criteria. This is done by algebraic manipulation of the formula below:

• Capital Cost (asset price) = Net Operating Income/ Capitalization Rate

For example, in valuing the projected sale price of an apartment building that produces a net operating income of $10,000, if we set a projected capitalization rate at 7%, then the asset value (or price we would pay to own it) is$142,857 (142,857 = 10,000 / .07).

This is often referred to as direct capitalization, and is commonly used for valuing income generating property in a real estate appraisal.

One advantage of capitalization rate valuation is that it is separate from a "market-comparables" approach to an appraisal (which compares 3 valuations: what other similar properties have sold for based on a comparison of physical, location and economic characteristics, actual replacement cost to re-build the structure in addition to the cost of the land and capitalization rates). Given the inefficiency of real estate markets, multiple approaches are generally preferred when valuing a real estate asset. Capitalization rates for similar properties, and particularly for "pure" income properties, are usually compared to ensure that estimated revenue is being properly valued.

### Cash flow defined

The capitalization rate is calculated using a measure of cash flow called net operating income (NOI), not net income. Generally, NOI is defined as income (earnings) before depreciation and interest expenses:

• Net Operating Income (NOI) = Net income – operating expenses (i.e., tax write-offs. depreciation, and mortgage interest are not factored into NOI); whereas Cash Flow = Net Operating Income (NOI) – Debt service

Depreciation in the tax and accounting sense is excluded from the valuation of the asset, because it does not directly affect the cash generated by the asset. To arrive at a more careful and realistic definition, however, estimated annual maintenance expenses or capital expenditures will be included in the non-interest expenses.

Although NOI is the generally accepted figure used for calculating cap rates (financing and depreciation are ignored), this is often referred to under various terms, including simply income.

## Use for comparison

Capitalization rates, or cap rates, provide a tool for investors to use for roughly valuing a property based on its Net Operating Income. For example, if a real estate investment provides $160,000 a year in Net Operating Income and similar properties have sold based on 8% cap rates, the subject property can be roughly valued at$2,000,000 because $160,000 divided by 8% (0.08) equals$2,000,000. A comparatively higher cap rate for a property would indicate greater risk associated with the investment (decreasing demand for the product, and the corresponding value), and a comparatively lower cap rate for a property might indicate less risk (increased demand for the product). Some factors considered in assessing risk include creditworthiness of a tenant, term of lease, quality and location of property, and general volatility of the market.

## Factors of Determination

Cap rates are determined by three major factors; the opportunity cost of capital, growth expectations, and risk.[1]

Commercial real estate investments compete with other assets (e.g. stocks and bonds) for investment dollars. If the opportunity cost of capital is too high, investors will use their capital to purchase other assets and the resulting decreased demand will drive prices down and cap rates up. If the inverse is true, cap rates will be driven down by the increased demand stemming from lower opportunity cost of capital.

The primary source of income in commercial real estate is rent. Rental rates are driven by a variety of supply and demand factors which make up a separate market for rentable space. As investors consider an acquisition, they must project future movements of this market as it relates to the specific asset. If the space market is expected to yield future increases in rental rates, investors will pay a higher price for the current income stream, pushing the cap rate down. If the space market projects a weak outlook, investors will want to pay less, and cap rates will rise.

Being a simplified rate of return measure, cap rates are subject to the same risk/return trade-off as other measures. In short, cap rates move in tandem with risk, real or perceived. While risk aversion varies from person to person, generally, investors are willing to pay more for less risky assets. As such, assets with less risk will carry lower cap rates than assets with higher risk.

## Reversionary

Property values based on capitalization rates are calculated on an "in-place" or "passing rent" basis, i.e. given the rental income generated from current tenancy agreements. In addition, a valuer also provides an Estimated Rental Value (ERV). The ERV states the valuer's opinion as to the open market rent which could reasonably be expected to be achieved on the subject property at the time of valuation.

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