Capitalization Rate:
If you’re just getting started in the business of commercial real estate, you may have already stumbled across the term “capitalization rate” or “cap rate” and wondered what it means and more importantly, how it affects you. If this applies to you then this article is worth the read as it will go over the definition, how to calculate, and the applications of a capitalization rate.
Firstly, a capitalization rate is a measurement that is used on an investment property to help calculate the expected rate of return on that property. This is a fast and easy way to estimate an investment’s potential returns as well as a quick way to estimate the duration of time a property will take to return the investment made on a property.
Although the cap rate can be used as a useful tool to quickly compare the relative value of investment properties in the market, it should not be used as the sole or predominating indicator for an investment’s viability as there are a number of factors that the cap rate doesn’t take into account:
Leverage: The total amount of debt financing on a property relative to its current market value
Time value of money: The concept that a sum of money is worth more now than the same sum will be in the future due to its earning potential.
Future cash flows due to property improvement: Adding features to a property can deftly improve the value of a property.
Understanding The Cap Rate’s Uses
The cap rate is the most popular measure for the assessment of a real estate investment’s profitability and rate of return and the reason for this favoritism is the simplicity and ease of use. The cap rate simply represents the potential yield of a property over a one-year period of time with the assumption that the property was purchased with cash and not with a loan. Ultimately, the cap rate represents the properties intrinsic and unlevered rate of return.
Now that the uses and application of the cap rate has been explained, its time to go over one of the most important details about a cap rate–the formula. However, there are several methods of computation for cap rate, we will first be going over the most popular version of computation:
Capitalization Rate = Net Operating Income / Current Market Value
Do not worry, you will not just have this formula sat there with no further explanation. There are a couple of portions to break down in this formula:
Net Operating Income: This is the expected annual income generated by the property after deducting all the expenses incurred by managing the property. Expenses include costs towards regular upkeep as well as property taxes
Current Market Value: The current market value of the asset as represented by the current and prevailing market rates.
In another version of the formula, current market value is replaced by the price at which the property was purchased. However, this second version of the formula is not as popular for a couple of reasons:
First: Can offer unrealistic results for older properties that were purchased during cheaper periods in the market
Second: Cannot be applied to inherited property because the purchasing price was nothing, thus making division impossible in the formula.
This has been a very brief overview of what a capitalization rate is and there are many variables that float around when trying to interpret a properties cap rate. It’s because of this high degree of variance that it is never a bad idea to outsource for help or guidance. Especially when there are no shortage of real estate agents in Tucson, AZ who are talented and eager to assist on your foray into commercial real estate!