Capitalization rate (cap rate)

Why Is The Capitalization Rate Important?

In investment real estate, the cap rate is the standard used in investment real estate practice to understand pricing and gauge expectations of returns in commercial real estate markets.

The cap rate is used to set prices, compare real estate investments, and analyze commercial real estate markets. It is the most practical and common pricing standard used in the industry.

Any real estate investor, or investment real estate professional must have a through understanding of cap rates to be proficient enough to participate in commercial real estate investment markets.

What Is The Capitalization Rate (the Cap Rate) In Real Estate?

The capitalization rate, also referred to as the cap rate, is a number that represents a rental property’s income as a percentage of that rental property’s market value. The cap rate is used to convert a property’s net operating income into the property’s investment value in a given market. Stated more simply, the cap rate turns the rental income into a market price for the rental property.

To illustrate how the capitalization rate is used, assume we know the cap rate in a given market for rental property is 10%. If we know a property’s income, we can calculate the market value for the rental property as an investment.

If a property’s net income is $10,000 for the year, then we can divide the $10,000 income by the cap rate of 10%. This means the market value of the property is $100,000 ($10,000 income / 10% cap rate = $100,000 market value).

The capitalization process allows us to work backward from two numbers that we can find out (the cap rate and the net operating income) to determine the market value of an investment property.

The capitalization rate is a component of the capitalization approach which is the process of converting an income into the corresponding amount of capital necessary to generate that income. In this case, the amount of capital needed to generate the income implies what the value of the investment asset is. In real estate, the investment asset is the rental property.

What Does the Capitalization Rate Mean in Layman’s Terms?

To illustrate the capitalization rate’s meaning in simple terms, the cap rate is like the interest you earn at the bank on the money you put in a savings account. If you put $100,000 in a savings account, and it earns you $10,000 in interest at the end of the year, then you earned 10% interest.

A rental property is an investment, much like a savings account. The income a rental property earns you is like the interest your money earns you in a savings account at the bank.

In the example above, if you invest $100,000 in the income property, the property will generate $10,000 of income at the end of the year. A cap rate of 10% means the property’s income is 10% of the rental property’s value.

If you know the interest rate a savings account pays (10%), and you know the amount of interest paid at the end of the year ($10,000), you could work backwards to calculate how much money you had in the account at the beginning of the year.

Divide $10,000 interest paid by the 10% interest rate, and you’d know you started with $100,000 in your savings account. This is the same concept of the capitalization approach that is used to calculate what an investment in a rental property should be.

The Capitalization Rate Formula

In the examples above, we’ve already used the capitalization rate equation to calculate an income property’s market value. The capitalization rate equation has three variables:

• the Capitalization Rate (Cap Rate)
• the Net Operating Income (NOI), and
• the Property Value

Calculating The Capitalization Rate

The capitalization rate is calculated from information that is sourced from comparable investment sales. Once a set of similar properties is assembled, we can use their net operating incomes and sales prices to determine an applicable cap rate for a given market.

The net operating income and the sales price for each property is plugged into the cap rate equation. The cap rate formula is NOI divided by sales price.

The Cap Rate Formula – Solving for the Capitalization Rate

Calculating The Investment Property Value

The market value of a rental property is calculated from the capitalization rate and the net income. The market value of investment property equals the NOI divided by the capitalization rate.

The net operating income will be determined from a pro forma cash flow statement, which is similar to an income statement, but adapted to real estate valuation by incorporating certain market assumptions.

As covered above, the cap rate is derived from the sales of comparable investment properties. Once the cap rate is established, we can apply the cap rate to determine the market value of a rental property.

The Cap Rate Formula – Solving for Market Value

Solving For Net Operating Income

The Net Operating Income is calculated in the pro forma cash flow statement, or is known from the rental property’s financial statements. The capitalization rate equation is useful to determine a cap rate or a market value, but it’s generally not used to calculate NOI.

However, the cap rate equation can also be used to solve for net operating income if the cap rate and sales price are known. This can be useful for cross checking the work behind calculating the property value, or useful to establish a target net operating income to achieve a certain price in the investment property market.

When using the cap rate equation to calculate net operating income from the cap rate, the NOI equals the property value multiplied by the capitalization rate.

The Cap Rate Formula – Solving for Net Operating Income

Comparing The Capitalization Rate To IRR and Other Returns On Investment (ROI)

Even though the capitalization rate seems to imply a certain rate of return on an investment, it is really more an indicator of the price of investment properties in a given market. It is a market determined rate derived from the sales of other comparable rental properties.

Market values are valid at a certain point in time under certain market conditions. Since the cap rate is a market derived rate, it is valid for the moment in time under the market conditions for which it is calculated.

This is partly because the net operation income (NOI) has been calculated for a single year in which the property is intended to be marketed, bought, or sold. Consequently, the cap rate is calculated for a single accounting period.

The capitalization rate does not consider the return on the investment over time, particularly when the rental property will be held over multiple years, only to be sold years later.

Another important characteristic of the capitalization rate is it converts an income of a property into an overall value, but real estate investors don’t put in the entire amount of money it takes to purchase investment properties. Instead, investors borrow money to supplement the cash they use to purchase rental property.

Using leverage means the actual capital invested in the rental property is less then the price paid on the property. This increases the rate of return on the capital actually contributed by the investor.

The Capitalization Rate Versus The IRR

The capitalization approach is more simple and practical in determining a market value for simple real estate investments than trying to do so using an internal rate of return.

The IRR is more sophisticated and accurate in determining what the return will be on an investment over time, but more complex. An additional advantage of an IRR is it is more practical in comparing returns of different investment types.

The internal rate of return (IRR) has the advantage of providing a return that considers the initial price of the property as well as multiple cash flows over multiple periods of time. The capitalization approach is focused on a single period or point in time for market value, and can’t be relied upon as what the actual return will be going forward.

Since the IRR method uses multiple periods, some skill and judgment is establishing the assumptions that are used to project future revenues and expenses. This information isn’t always readily available.

The advantage of the capitalization approach is that it uses market values and income assumptions that are more readily available.

The Capitalization Rate Versus The Return On Investment (ROI)

The capitalization approach uses a rate to determine the value of an investment. The return on investment (ROI) can mean several different types of returns in the investment world. It may refer to a Return on Assets (ROA) or a Return On Equity (ROE). In investment real estate, there is also a Cash On Cash return.

The cap rate is similar to return on assets. The ROA is the net income as a percentage of the total value of the assets used to generate that income. However, the ROA is used as an actual measure of the productivity of income producing assets.

The cap rate is used to work backward to estimate the market value of an asset that is based on a pro forma net operating income. The ROA is a measure of the actual productivity of an asset in generating net income.

Equity is that residual claim investors have on an assets after accounting for all the debts and liabilities. The return on equity (ROE) is the income generated by the assets as a percentage of the investors equity.

In real estate, investors generally contribute a portion of the money, then borrow the rest to acquire the investment asset. The return on equity measures the income relative to the investors equity in the asset, not as a portion of the value of the entire asset.

Similarly, the cash on cash return measures income relative to the initial cash investors bring to a deal, not the entire asset value of the rental property.

The Entry Cap Rate And The Cap Rate At Reversion

The capitalization rate is used to price rental property at a given point in time in the property market. This means that during a life of an investment, the cap rate is used to establish a value when the investment property is purchased, or when it is sold.

When analyzing a return of an investment over time, all the cash flows of the investment property are taken into consideration to calculate the total return. This means considering the cash outflow when the investor purchases the property, and the cash the investor receives when the property is sold at the end of the holding period.

The going in cap rate is the cap rate used to determine the value of the property when the investor buys the real estate. Since the investor is entering the investment, can also be referred to as the entry cap rate.

The going out cap rate is the cap rate used to determine the price of the investment when the investor sells and exits the investment. Since the investor is exiting the investment, this cap rate is also known as the exit cap rate.

The cap rate at reversion is also synonymous with the exit cap rate, or the cap rate going out. The term reversion is used because it is the cap rate used at the sale of the investment real estate when the proceeds revert back to the investor.

The Capitalization Rate – A Measure Of Price and Return

The capitalization rate is partly a measure of return, and partly an indicator of the price of rental property in the commercial real estate investment market. As investors look at where to invest their money, they look at the return their investment will earn them.

There are several factors that influence cap rates, and hence prices of investment real estate. However, all of these factors revolve around supply and demand in investment real estate markets.

Inverse Relationship Between Capitalization Rates And Investment Real Estate Prices

Like any market, when more and more people try to buy something, they end up bidding the price up. The same is true in investment real estate. If more and more investors compete to own a handful of investments, they bid up the price of those investments.

From the mindset of investors who compete against each other to place their capital in an investment, they will think “I will take a little less return then the other investors so I can buy that rental property.”

In term of prices and cap rates, this shows a very important relationship between prices and cap rates. As investors bid prices up, cap rates go down. This means there is an inverse relationship between cap rates and investment real estate prices. Thus, the more attractive an investment market is to investors, the lower the cap rates will be.

The reverse is also true. The higher the cap rate, the lower the price of the investment property. This means investment markets with higher cap rates tend to be less desirable. If the seller of an investment property wants to make the price of a property a little more attractive, then the seller will have to offer a little more return in exchange for the investor’s capital.

The lower the cap rate, the higher the price.

The higher the cap rate, the lower the price.

Capitalization Rate Compression

Understanding the inverse relationship between cap rates and price is key to understanding what is meant by cap rate compression. Cap rate compression is the tendency of a market to force prices up, and hence put downward pressures on cap rates.

Cap rate compression is used to describe markets where competitive investors bid up real estate prices. It is caused by any combination of factors that increase demand for investment real estate, or restrict supply of commercial real estate investments.

The Risk Component of the Capitalization Rate

In any measure of investment return, there is a component that compensates for risk. In investment parlance, this is said to be the risk adjusted rate of return. In simple terms, it means:

The greater the risk, the greater the return.

The lower the risk, the lower the return.

Since the capitalization rate reflects an expected return, it also implies that the cap rate reflects the market’s perceived level of risk for a particular asset in a given market. All other things being equal, the higher the cap rate, the higher the risk.

It should be noted that risk is just one vector that goes into determining an investment’s return, while there are many other supply and demand vectors that influence the level of return investors are willing to accept.

Holding all these factors contant, ceteris peribus, there is generally a reason why certain properties sell at higher cap rates, and hence lower prices to attract buyers. Careful market analysis, due diligence, and knowledgeable advisors are essential in identifying the risks of any commercial real estate investment.

The Capitalization Rate As The Market Standard

The capitalization rate provides a common ground upon which to compare investment assets and markets that encapsulates supply and demand, risk, value, and return.

This means that despite the diversity of property types and markets, each investment can initially be distilled down into a capitalization rate. The reason is an investor is really buying a stream of income at an acceptable level of risk.

Whatever real estate market or property type an investor invests in, they are looking for a stream of income. Whether the property is an apartment building, hotel, industrial building, office tower, or net leased investment, they all generate a net operating income that the investor is paying for.

Consequently, the price of the property is meaningless without some understanding of the expected return the property generates its investors. This means the cap rate is a useful tool that can be used understand market dynamics, to compare returns of different properties and different markets, and establish values.

The cap rate provides a pricing standard to the broad scope of a real estate investors that can range from a local investor that is focused on a particular neighborhood or city, to a commercial real estate investor that owns investment properties across the country.

What Is A Good Capitalization Rate?

With an in depth understanding of the capitalization rate, is it possible to establish a good cap rate? A good cap rate is entirely subjective. It depends on whether the investor is the buyer or the seller. It also depends on their objectives and situations.

All things being equal (ceteris peribus), a seller will benefit from lower cap rates, increasing the price of the asset when it comes time to sell. This translates into greater capital gains for the seller. Conversely, it means a higher acquisition cost to the buyer.

Buyers will benefit from higher cap rates, which mean lower prices. Paying less to acquire an investment property means lower entry cost into the investment. It can also mean the potential for greater return, and more potential for upside in the asset.