Capitalization rate (or Cap Rate for short) is commonly used in real estate and refers to the rate of return on a property based on the net operating income (NOI) that the property generates. In other words, capitalization rate is a return metric that is used to determine the potential return on investment or payback of capital.
The formula for Cap Rate is equal to Net Operating Income (NOI) divided by the current market value of the asset.
Net operating income is the annual income generated by the property after deducting all expenses that are incurred from operations including managing the property and paying taxes.
Current market value of the asset is the value of an asset on the marketplace.
Importance of Capitalization Rate
The capitalization rate is used to compare different investment opportunities. For example, if all else equal, a property with a 10% cap rate versus another property’s 3%, an investor is most likely to focus on the property with a 10% cap rate.
The rate also indicates the amount of time it takes to recover an investment in a property. For example, if a property comes with a 10% cap, it will take 10 years for the investor to recover his investment (called “fully capitalized”).
Although it’s an important metric in comparing investment opportunities, investors should never base a purchase on the cap rate of a property alone. It is useful to note that different cap rates represent different levels of risk – a low cap rate implies lower risk while a high cap rate implies higher risk. Therefore, there is no “optimal” cap rate – it depends on the investor’s risk preference.
For example, consider two properties in different geographical locations – one is in a highly coveted suburban region while the other is in a run-down part of the city. The property in the highly coveted suburban region would show a lower cap through the high market value of the asset. On the contrary, the property located in the run-down part of the city would come with a higher cap, reflected by the lower market value of that asset.
Cap Rate Example
John is an investor looking to buy an investment property. From taking real estate courses, he remembers that the capitalization rate is an effective metric in evaluating real estate properties. John identifies three properties with their respective expenses, annual income, and market values:
After doing the calculations for the properties above, John realizes that Property C returns the highest cap rate.
In a simple world, John may base his purchase on the rate alone. However, it is just one of many metrics that can be used to assess the return on commercial real estate property. Although cap rate gives a good idea of a property’s theoretical return on investment, it should be used in conjunction with other metrics such as the gross rent multiplier, among many others. Therefore, other metrics should be used in conjunction with the capitalization rate to gauge the attractiveness of a real estate opportunity.
Real Estate Modeling Course
If you want to learn all about how to calculate net operating income, capitalization rates, and even how to build a financial model for a development project, check out CFI’s Real Estate Financial Modeling Course. The program will teach you how to build a model in Excel from scratch.
Cap Rate Summary
The capitalization rate is a profitability metric used to determine the return on investment of a real estate property.
The formula for the capitalization rate is calculated as net operating income divided by the current market value of the asset.
The capitalization rate can be used to determine the riskiness of an investment opportunity – a high capitalization rate implies higher risk while a low capitalization rate implies lower risk.
The capitalization rate should be used in conjunction with other metrics and investors should never base a purchase on the capitalization rate of a property alone.
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