The capitalization rate (also known as cap rate) is used in the world of commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property. This measure is computed based on the net income which the property is expected to generate and is calculated by dividing net operating income by property asset value and is expressed as a percentage. It is used to estimate the investor’s potential return on their investment in the real estate market.
While the cap rate can be useful for quickly comparing the relative value of similar real estate investments in the market, it should not be used as the sole indicator of an investment’s strength because it does not take into account leverage, the time value of money and future cash flows from property improvements, among other factors. There are no clear ranges for a good or bad cap rate, and they largely depend on the context of the property and the market.
Several versions exist for the computation of the capitalization rate. In the most popular formula, the capitalization rate of a real estate investment is calculated by dividing the property’s net operating income (NOI) by the current market value. Mathematically,
Capitalization Rate = Net Operating Income / Current Market Value
The net operating income is the (expected) annual income generated by the property (like rentals) and is arrived at by deducting all the expenses incurred for managing the property. These expenses include the cost paid towards the regular upkeep of the facility as well as the property taxes.
The current market value of the asset is the present-day value of the property as per the prevailing market rates.
In another version, the figure is computed based on the original capital cost or the acquisition cost of a property.
Capitalization Rate = Net Operating Income / Purchase Price
However, the second version is not very popular for two reasons. First, it gives unrealistic results for old properties that were purchased several years/decades ago at low prices, and second, it cannot be applied to the inherited property as their purchase price is zero making the division impossible.
Additionally, since property prices fluctuate widely, the first version using the current market price is a more accurate representation as compared to the second one which uses the fixed value original purchase price.
Cap rates can also be used to quickly estimate a property’s value when considering a refinance. If a property owner wants to consider a refinance, they may need an estimated value to determine what potential loan amount the property supports using the lender’s loan to value (LTV) metric. Once the estimated value is calculated, the owner can determine whether a refinance is possible, or even worth it.
Some buyers use future estimated cap rates to model the projected return of a property before it is purchased. A financial “model” is put together in excel to determine a project’s projected return profile and to see if it meets the buyer’s return targets. The model uses the purchase price, closing costs, the senior debt, projected income and expenses with growth over the anticipated hold period, as well as a projected exit price and potential profit. In order for a buyer to complete the data inputs in a model and reach a projected internal rate of return (IRR), many unknown figures must be assumed using available market data. For example, Axiometrics, a provider for multifamily data, issues reports that show what the projected market rent growth is in a submarket so buyers can incorporate those rent growth numbers into their model. CoStar, another commercial real estate data provider, offers historic cap rates for markets and submarkets which helps buyers determine reasonable cap rates for that market when estimating the exit price of the asset at the end of the projected hold period
While Cap Rates are a useful metric, they should not be relied upon solely when analyzing an investment property, and have certain shortcomings.
Assume that an investor has $1 million and he is considering investing in one of the two available investment options – one, he can invest in government-issued treasury bonds that offer a nominal 3 percent annual interest and are considered the safest investments and two, he can purchase a commercial building that has multiple tenants who are expected to pay regular rent.
In the second case, assume that the total rent received per year is $90,000 and the investor needs to pay a total of $20,000 towards various maintenance costs and property taxes. It leaves the net income from the property investment at $70,000. Assume that during the first year, the property value remains steady at the original buy price of $1 million.
The capitalization rate will be computed as (Net Operating Income/Property Value) = $70,000/$1 million = 7%.
This return of 7 percent generated from the property investment fares better than the standard return of 3 percent available from the risk-free treasury bonds. The extra 4 percent represents the return for the risk taken by the investor by investing in the property market as against investing in the safest treasury bonds which come with zero risk.
Property investment is risky, and there can be several scenarios where the return, as represented by the capitalization rate measure, can vary widely.
For instance, a few of the tenants may move out and the rental income from the property may diminish to $40,000. Reducing the $20,000 towards various maintenance costs and property taxes, and assuming that property value stays at $1 million, the capitalization rate comes to ($20,000 / $1 million) = 2%. This value is less than the return available from risk-free bonds.
In another scenario, assume that the rental income stays at the original $90,000, but the maintenance cost and/or the property tax increases significantly, to say $50,000. The capitalization rate will then be ($40,000/$1 million) = 4%.
In another case, if the current market value of the property itself diminishes, to say $800,000, with the rental income and various costs remaining the same, the capitalization rate will increase to $70,000/$800,000 = 8.75%.
In essence, varying levels of income that gets generated from the property, expenses related to the property and the current market valuation of the property can significantly change the capitalization rate.
The surplus return, which is theoretically available to property investors over and above the treasury bond investments, can be attributed to the associated risks that lead to the above-mentioned scenarios. The risk factors include:
Age, location, and status of the property
Property type – multifamily, office, industrial, retail or recreational
Tenants’ solvency and regular receipts of rentals
Term and structure of tenant lease(s)
The overall market rate of the property and the factors affecting its valuation
Macroeconomic fundamentals of the region as well as factors impacting tenants’ businesses