What Is the Capitalization Rate?

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.

The capitalization rate is calculated by dividing a property’s net operating income by the current market value.

This ratio, expressed as a percentage, is an estimation of an investor’s potential return on a real estate investment.

The cap rate is most useful as a comparison of the relative value of similar real estate investments.

Understanding the Capitalization Rate

The cap rate is the most popular measure through which real estate investments are assessed for their profitability and return potential. The cap rate simply represents the yield of a property over a one-year time horizon assuming the property is purchased on cash and not on loan. The capitalization rate indicates the property’s intrinsic, natural, and un-levered rate of return.

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

where,

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.

Those interested in learning more about capitalization rates may want to consider enrolling in one of the best online real estate schools.

Interpreting the Capitalization Rate

Since cap rates are based on the projected estimates of future income, they are subject to high variance. It then becomes important to understand what constitutes a good cap rate for an investment property.

The rate also indicates the duration of time it will take to recover the invested amount in a property. For instance, a property having a cap rate of 10% will take around 10 years for recovering the investment.

Different cap rates among different properties, or different cap rates across different time horizons on the same property, represent different levels of risk. A look at the formula indicates that the cap rate value will be higher for properties that generate higher net operating income and have a lower valuation, and vice versa.

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.

Say, there are two properties that are similar in all attributes except for being geographically apart. One is in a posh city center area while the other is on the outskirts of the city.

All things being equal, the first property will generate a higher rental compared to the second one, but those will be partially offset by the higher cost of maintenance and higher taxes. The city center property will have a relatively lower cap rate compared to the second one owing to its significantly high market value.

It indicates that a lower value cap rate corresponds to better valuation and a better prospect of returns with a lower level of risk. On the other hand, a higher value of cap rate implies relatively lower prospects of return on property investment, and hence a higher level of risk.

While the above hypothetical example makes it an easy choice for an investor to go with the property in the city center, real-world scenarios may not be that straightforward. The investor assessing a property on the basis of the cap rate faces the challenging task to determine the suitable cap rate for a given level of risk.

Gordon Model Representation for Cap Rate

Another representation of the cap rate comes from the Gordon Growth Model, which is also called the dividend discount model (DDM). It is a method for calculating the intrinsic value of a company’s stock price independent of the current market conditions, and the stock value is calculated as the present value of a stock’s future dividends. Mathematically,

Stock Value = Expected Annual Dividend Cash Flow / (Investor’s Required Rate of Return – Expected Dividend Growth Rate)

Rearranging the equation and generalizing the formula beyond dividend,

(Required Rate of Return – Expected Growth Rate) = Expected Cash Flow / Asset Value

The above representation matches the basic formula of the capitalization rate mentioned in the earlier section.

The expected cash flow value represents the net operating income and the asset value matches the current market price of the property.

This leads to the capitalization rate being equivalent to the difference between the required rate of return and the expected growth rate. That is, the cap rate is simply the required rate of return minus the growth rate.

This can be used to assess the valuation of a property for a given rate of return expected by the investor. For instance, say the net operating income of a property is Rs.50,000, and it is expected to rise by 2% annually.

If the investor’s expected rate of return is 10% per annum, then the net cap rate will come to (10% – 2%) = 8%.

Using it in the above formula, the asset valuation comes to (Rs.50,000 / 8%) = Rs.625,000.

Limitations of the Cap Rate

Although capitalization rate can be a useful metric for properties that provide stable income, it is less reliable if a property has irregular or inconsistent cash flows. In these circumstances, a discounted cash flow model might be a better way to measure the returns from an investment property.

The capitalization rate is only useful to the extent that a property’s income will remain stable over the long term. It does not take into account future risks, such as depreciation, or structural changes in the rental market that could cause income fluctuations. Investors should take these risks into account when relying on cap rate calculations.

What Is a Good Cap Rate?

There is no single value for what makes an “ideal” capitalization rate, and investors should consider their own risk appetites when evaluating a property. Generally, a high capitalization rate will indicate a higher level of risk, while a lower capitalization rate indicates lower returns but lower risk.

That said, many analysts consider a “good” cap rate to be around 5% to 10%, while a 4% cap rate indicates lower risk but a longer timeline to recoup an investment.1 There are also other factors to consider, like the features of a local property market, and it is important not to rely on cap rate or any other single metric.

What Affects the Cap Rate?

There are many potential market factors that can affect the capitalization rate of a property. As with other rental properties, location plays a major factor in determining the returns of commercial properties, with high-traffic areas likely to come with a higher capitalization rate.

It is also important to consider other features of the local market, such as competing properties. Generally, properties in a large, well-developed market will tend to have lower capitalization rates, due to competitive pressures from other businesses. Future trends, such as local market growth, can also affect the long-term capitalization rate for a property.

Finally, the amount of capital you invest in a property can also affect the cap rate. A renovation that makes a property more attractive could command higher rents, increasing the owner’s operating income.

Examples of the Capitalization Rate

Assume that John has Rs.10 lakh and he is considering investing in one of the two available investment options:

1. He can invest in government-issued Treasury bonds that offer a nominal 3% annual interest and are considered the safest investments,

or

2. 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 Rs.90,000 and the investor needs to pay a total of Rs.20,000 towards various maintenance costs and property taxes. It leaves the net income from the property investment at Rs.70,000. Assume that during the first year, the property value remains steady at the original buy price of Rs.10 Lakh.

The capitalization rate will be computed as (Net Operating Income/Property Value) = Rs.70,000/Rs.10,00,000 = 7%.

This return of 7% generated from the property investment fares better than the standard return of 3% available from the risk-free Treasury bonds. The extra 4% 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.

Uses of Cap Rate :

As we know Cap Rate is the ratio of Net Operating Income (rentals) to the asset value, for example, if the rentals earned by a commercial building is Rs 20 lakh per annum and the sale price of the building is Rs 1 crore, then the Cap Rate would be 20 percent. It is important to note that expenses on the rental income like taxes and maintenance costs must be subtracted from the rental earning to arrive as Net Operating Income.

A Cap Rate, in some ways, lets an investor of a commercial property know how much return will he or she get. So in the example given above, an investor will get 20 percent return on purchasing the building for Rs 1 crore in an all-cash deal.

A Cap Rate can be used to find out the earning potential from investment in a commercial property. Another use of the Cap Rate is to find out the value of a property if the Cap Rate and Net Operating Income of the building is known. For example, if the Net Operating Income is Rs 25 lakh and the Cap Rate is 10 percent, then using the same formula, we can arrive at the valuation of the building which is Rs 2.5 crore in this case. In the second example, the investor can recover the investment in 10 years, and the in the first example, the investor can recover the investment in 5 years. Thus, the higher the Cap Rate the lower would be the time to recover the investment and vice versa.

A Cap Rate can also be used to predict a particular property market and where it is heading. This is especially true for a micro market or a particular locality or street. A trend of the car rates prevailing in the last 5, 10 or 15 years can give a fair idea as to whether the valuations are headed upwards or downwards. These trends can further help in taking a decision on whether a certain property has to be acquired or not. If there is a falling trend in the Cap Rates, that means the valuation is going up in that micro market and the market is heating up. What will be the valuation in the coming years can be found out by using Cap Rates?

The Cap Rates can be useful in future valuation only when there is a clear historical trend. If there has been wild fluctuation in the rental incomes from one year to another then merely using Cap Rate to arrive at valuation may not work. There can be sudden variations in rental incomes in particular sub-markets because of the development of infrastructure in that area or some regulatory change impacting the business conducting potential in that locality.

Capitalization Rate on Property

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 Rs.40,000. Reducing the Rs.20,000 towards various maintenance costs and property taxes, and assuming that property value stays at Rs.10 Lakh, the capitalization rate comes to (Rs.20,000 / Rs.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 Rs.90,000, but the maintenance cost and/or the property tax increases significantly, to say Rs.50,000. The capitalization rate will then be (Rs.40,000/Rs.10,00,00) = 4%.

Pay attention to rates. In general, cap rates increase when interest rates go up.

In another case, if the current market value of the property itself diminishes, to say Rs.8,00,000, with the rental income and various costs remaining the same, the capitalization rate will increase to Rs.70,000/Rs.800,000 = 8.75%.

In essence, varying levels of income that get 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:

1. Age, location, and status of the property
2. Property type: Multifamily, office, industrial, retail, or recreational
3. Tenants’ solvency and regular receipts of rentals

Term and structure of tenant lease(s)

4. The overall market rate of the property and the factors affecting its valuation
5. Macroeconomic fundamentals of the region as well as factors impacting tenants’ businesses

Is a Higher or Lower Capitalization Rate Better?

Generally, the capitalization rate can be viewed as a measure of risk. So determining whether a higher or lower cap rate is better will depend on the investor and their risk profile. A higher cap rate means that the investor holds more risk whereas a low cap risk means an investment holds less risk.

What Is the Difference Between the Capitalization Rate and Return on Investment?

Return on investment indicates what the potential return of an investment could be over a specific time horizon. The capitalization rate will tell you what the return of investment is currently or what it should actually be.

ROI is arrived at by dividing the Cash Flow by the Down payment for purchasing the building.

For example, if the Net Operating Income from a property is Rs 2 lakh and the EMI payment for loans is Rs 5,000 (Rs 60,000 yearly) then the Cash Flow will be Rs 1,40,000 (Rs 2 lakh minus Rs 60,000). The down payment for the building is, lets say, Rs 5 lakh. ROI in this case will be Rs 1,40,000 divided by Rs 5 lakh, that is, 0.28 or 28 percent.

ROI will let the investor know the true picture of the income by investing in a property if a loan is availed in purchasing the property. Cap rate is useful in cases where there is no financing or mortgage is involved and the property is purchased on a self-financing basis.

What Should My Capitalization Rate Be IN the Indian Scenario?

The capitalization rate for investment property should be between 4% and 10%. The exact number will depend on the location of the property as well as the rate of return required to make the investment worthwhile. The Cap Rates in India are trending towards compression, that is, they have demonstrated a declining tendency over the last decade or so. This is because a number of private equity (PE) investors and international pension funds have been active in picking up property in India and that is causing the valuations of the property to go up.

The Cap Rate in the country has now come down to about 7.5-9 percent from about 11 percent that stood a decade ago. Property experts feel that the Cap Rates can further go down by around 1-2 percent in the next 5-8 years, on account of heightened interest by foreign institutional investors taking the property valuations further up.

Conclusion

The capitalization rate is used to measure the profitability of commercial rental properties. A high cap rate indicates a relatively high income, relative to the size of the initial investment. However, there are also other factors to consider, such as risk and local market dynamics. Investors should be careful to consider a wide range of metrics in addition to the capitalization rate