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Capitalization Rate

DEFINITION

The concept is simple but the definition of a capitalization rate is not. It is also known as a “cap rate” for a shorter version of the term. This rate is the return on an investment into real estate holdings that is calculated by the income that the property in question is estimated to make. Such a metric is utilized to make an estimation of a potential investors return on their investments into the property. To calculate a capitalization rate, you take the net operating income of the property and divide it by the property’s market value at the current time. The formula used to do this looks a bit like this: NOI (net operating income) / Market Value = Capitalization Rate. If the Market Value is in flux, then you can also use the value at the time of property acquisition to get an estimation of the capitalization rate.

EXPLANATION

What You Need To Know

The fundamental concept of a capitalization rate is a staple of the real estate industry. And yet most people misunderstand capitalization rates and even misuse them. So let’s take an in-depth look into cap rates and get a few things straight.

What Exactly Is A “Cap Rate”

A cap rate is a ratio of the property’s net asset value to the net operating income or NOI. If a property is sold for a million dollars and has a net operating income of one hundred thousand dollars, the capitalization rate would be ten percent of that.

Example Of A Cap Rate

Look at this example of how a cap rate is customarily used. Say you are researching a recent sale of a Class A office space building containing a net operating income that is stabilized at a million dollars and is sold for seventeen million dollars. It would be normal to say that this office space property was sold at 5.8% of the capitalization rate.

Let’s Break Cap Rate Down

In simple words, a cap rate can be used as a tool when it is time to compare similar properties on the real estate market for investments. Say someone named Bob wants to purchase an investment property for nine hundred thousand dollars. They may expect it will gain one hundred and twenty-five thousand dollars a year after the deduction of operating costs. This cape rate investment would be a return of 13.9%.

125,000/900,000 = 0.1389 = 13.9

Once Bob returns to searching for a good investment real estate property, he can use this expected cap rate to compare similar investment opportunities within the same price bracket after all operating costs.

A Much More Complicated Picture

Sadly, it is not really this simple in the real world marketplace. Cap rates are one of the most sophisticated and complicated applications in the real estate investment market. If we add to Mr. Bob’s example, let’s assume that he locates another commercial real estate investment but with a cap rate of seven percent.

In a fantasy world like the one mentioned above, you could make your decision based on the cap rate. Bob could smoothly go with his first choice for a new investment opportunity. However, if the commercial building is older and in need of a remodel, then it may not be the best choice. On the other hand, if a building with a slightly different cap rate has more assets or long-term corporate leases, it stands to reason that Bob could make more money on returns from it. Think of an older apartment building that is well kept and has more amenities with a slightly lower cap rate. Bob will make more money off that one rather than an old beat up apartment building with few facilities. Sometimes, newer real estate holdings with lower cap rates are better investments, too. This causes more complication. You cannot just look at the capitalization rates alone. Observe everything about the real estate property you want to purchase before investing in it.

If Bob chose not to do this, he could invest in an older commercial building such as an apartment complex that needs renovations. It could also have many vacancies. While the return rate is higher with some of these options, it is usually because the risks are higher, which may lower returns as time goes by. Think of it as a risk premium for investing in the property. A higher capitalization rate doesn’t always mean that it is a higher risk investment property, but it could. Remember that the cap rate is just one of many factors for evaluating investment properties.

Adjustments Of Capitalization Rates

Recall that cap rate helps gauge how profitable a property will be. Net Operating Income must remain the same constantly for the cap rate to stay the same because the NOI proportion is a factor in the cap rate. If the Net Operating Income drops and the value on the market do not, then the property will be less profitable. If the NOI goes up without a market value change, then the property will produce even better returns. Basically, the capitalization rate rises when the NOI does and falls when the NOI does, as long as the market value of the property stays the same. The market value dropping or rising can change both or just the capitalization rate. Obviously, a falling cap rate means that investing elsewhere would be wiser. Still, be wary of a rising cap rate as it might also mean a higher risk investment.

How Really Look At A Cap Rate

Think of the cap rate a bit like this; the rate is a percentage representing the amount you should receive in return investments. This is typically only true of a complete cash purchase of the commercial property. If we presume that the real estate amounts are correct, a cash purchase of seventeen million dollars should produce a yearly return of 5.8%. Essentially, It is just the amount paid inverse to the amount returned on the investment.

What Makes For A Good Cap Rate?

There is a short answer and a long answer here. Let’s start with the short answer first. It really depends on what you’re doing with the cap rate. If you’re putting an investment property on the market, then a lower cap rate will bring a higher property value. On the other end, if you’re purchasing, then a higher cap rate is preferred as it will mean a lower investment at the start of the endeavor.

If you are trying to find a market-based capitalization rate going by sales recently made on comparable properties, then a good cap rate is derived from similar features with a good cap rate in the same area. This works out well as long as the comparable cap rates you’re looking at are in the same area. If you look at properties too far away from your interest point investment property, they won’t be relevant to the one you’re looking at. If you’re looking at office space, then look at similar office buildings in the same general area or part of a city/town. Don’t bother looking at other properties in differing markets.

Don’t Always Rely On A Capitalization Rate

As a useful and common ratio utilized in real estate, it is beneficial in the right situation. However, cap rates are not helpful when the net operating income varies or is irregular. This is where further investigation is needed to at least figure out why the NOI is not acting normally. You could also just look at better investment opportunities.

When A Cap Rate Is Most Useful

The cap rate of a property should be similar to other cap rates in the area. If one property has a five percent cap rate while the one next to it has a ten percent cap rate, it tells you that the ten percent cap rate is a higher risk investment. This is obviously an excellent way to size up different investment options on the commercial real estate market. You can also use cap rates to track market trends. If capitalization rates are compressing or lower across the board in one area, it means market prices are rising, and the market is becoming more hostile to buyers bidding for investment properties. Want to know where the market will go in the next year? Just look at previous years cap rates for a clue. Chances are there is a trend to be followed.

Main Factors Of The Capitalization Rate

As you can imagine, there are many components to the cap rate that determine it and many other things relating to commercial investments. This includes but is not limited to the following:

▏            The Properties Age.

▏            The credit scores of the tenants.

▏            The tenant’s diversity.

▏            The lease lengths of the tenants.

▏            The supply and demand for the asset class in question.

▏            Factors for the general area like population growth, employment rates and how much comparable investments are on the current market.

When you look at all these factors and break each of them down, it is simple to notice their correlation to the capitalization rate and the investment market as a whole. With changes in each factor comes percentage changes in cap rates. Every commercial and residential property value is subject to changes in these factors. While residential properties are impacted by such considerations, commercial properties are far more affected by such changes.

Capitalization Rate Summary

In short, the capitalization rate or cap rate is determined by dividing the net operating income by the standing market value of the commercial property. It can be used to gauge if the property is a good investment or a bad one. However, it should not be any investors only source of information on an investment property. There are many factors that go into the cap rate and specific cap rates that look good can still be high-risk investments. Still, capitalization rates are still are a handy tool on the commercial real estate investment market. The trick is to use the cap rate along with other knowledge of investing in commercial properties, and there are few times a cap rate should be ignored.

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