Capitalization rate (or “cap rate”) is the ratio between the net operating income produced by an asset and its capital cost (the original price paid to buy the asset) or its current market value.
The rate is calculated in a simple fashion as follows:
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 is subtracted from gross leaseincome) 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, his cap rate would be:
- $100,000 / $200,000 = 0.50 = 50%.
However, the investor must take into account the opportunity cost of keeping his money tied up in this investment. While keeping this building, he is losing the opportunity of investing $1,000,000 by not selling the building at its market value and investing the proceeds. If a building worth a million dollars brings in a net of one hundred thousand dollars a year, then the cap rate is Ten Percent. 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 Ten Percent, not Fifty Percent, and he has a million dollars invested, not two hundred thousand.
Here is another example of how 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 Percent divided by 10 Percent). If the capitalization rate were 5 Percent, 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. When 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, or 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 Percent 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 Percent, 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 (tax write-offs i.e. 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; 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.