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What Is Cap Rate? Understanding The Capitalization Rate Formula

Article writer - David Saba image

Formula used to arrive at a ratio that gauges the profitability of an investment in Real Estate.

The Capitalization rate is a formula that is used to arrive at a ratio that gauges the profitability of an investment in real estate. Before an investment is made in residential real estate, the capitalization rate or "Cap Rate" as commonly referred to has to be calculated to assess the percentage return that would be made on the investment.

Definition of Cap Rate

The cap rate of a residential property is the ratio of Net Operating Income to the asset value of property multiplied by 100%. The Capitalization Rate can therefore be calculated as Cap Rate= where the annual Net Operating Income is the income generated after all the operating and maintenance costs have been deducted.

Example of Cap Rate Calculation

If we take the Annual Net Operating Income of a residential real estate property to be $30,000 while the total cost value of the property as $300,000. The Cap Rate will be 10% which represents the average percentage of return that can be expected annually from an investment made. Repairs and other workable costs to be incurred should be part of the total cost of the property before the Cap Rate is calculated to ensure the total investment is captured and expected percentage returns effectively evaluated.

Evaluating Cap Rate

The Cap Rate is an effective way to determine the percentage return an investor can expect when an all cash investment in real estate is made. The Capitalization rate is a direct inverse of the Price to Earnings multiple. The Cap Rates represent a risk free rate of return with together with the risk premium.

When placing it in perspective, there are risk free investments like treasury bonds while real estate investments come with a level of risk. While a risk free investment can bring a low return of 3%, a risky investment in real estate can bring a higher return of 5%. The extra 2% of returns represents the risk and calculation of the Cap Rate is what aids identify the margin. The 2% risk premium to be received from real estate as opposed to treasury bonds investments may be due to additional factors like age of the property, tenant reliability growth of the industry and recession. Taking the risk can ensure an investor gets the extra 2% of margins of returns as opposed to taking a risk free investment that will have lower returns over time.

What it says in potential investment

The Cap Rate is an effective pointer to the potential returns an investor can get. It is an indicator of the effective capacity of a property in sustaining a return on investment. When evaluating potential investment, the Cap Rate is what evaluates the risk return.

When to use Cap Rate Calculations

The Cap Rate can be used in varied real estate investment situations including:

Evaluating Potential Investments

Cap Rates are effective in managing the evaluation of an acquisition. Before investing in a residential real estate property, comparing the Cap Rates of the respective properties can give a definite solution as to which property is worth the while. It aids in scrutinizing an investment relative to other properties within the same investment range.

If we take residential properties in the same locality and with same overall asset value but with different Net Operating Incomes. The higher Cap Rate will be preferable as it will ensure a quick return on investment.

Take asset values of 2 different properties to be $700,000 but property A to have a Net Operating Income of $50,000 while property B has $70,000. This means property A will have a Cap Rate of 14% while that of property B will have a Cap Rate 10%. When making an investment, property A will be more valuable as an investment as it will have greater returns.

Evaluating Trends

The Cap Rate can be used to evaluate the trends of real estate properties over time. Trends in residential real estate usually take two orientations where they can either be compressing or scaling. A compressing Cap Rate means that property values are rising which indicates a high market demand. A scaling Cap rate means that property values are declining and that the market is slowing down.

Calculating the Cap rates can effectively point towards where the market is headed which will inform an investment decision.

Understanding Payback Period

The payback period for a residential property indicates the time period it will take for the returns to cover the investment made. As the Cap Rate provides an annual percentage of expected income, the number of years it will take to get the full amount of the investment is calculated by dividing the Cap Rate by 100.

If we take the Cap Rate of a particular property A to be 10% dividing it by 100 will give 10 which represents the number of years it will take to get the principle investment back.

However, the Net Operating Income and the asset value of the property may not remain the same over the period which means that although it is a way of calculating the payback period, it is not accurate since the real estate market is volatile and can fluctuate.

When Not To Use Cap Rate

There are some cases when using Cap Rate calculations will not yield the correct depiction of what the real estate market is like. The cases where using Cap Rates is not advisable include:

Property Has Complex Cash Flow

Properties with a complex cash flow indicate a variation in the Net Operating Income which in turn affects the ratio of the Cap Rate. When the net operating stream of a property is irregular, making a definite projection of the Net Operating income becomes impossible. With residential properties having complex Net operating streams, Cap Rates may not provide a definite evaluation of the cost of the property and the potential income. A full discounted cash flow analysis is the effective path of calculation that can determine Net Operating Streams for such properties.

Short Term Investments

Short term investments do not submit to the formula of calculating returns on investment. Investment in a real estate property A may be made when there is a compression on the market and eventually sold on the short term when the market has scaled. This means an irregular and fluctuating Cap Rate ratio which may mislead an investment.

Understanding Net Operating Income

The Net Operating Income or otherwise denoted as NOI is a function that gives the net returns that are to be expected from an investment. It is calculated from the formula:

Net Operating Income= Total Income from property - Total Operating costs

The NOI is reflective of the net amount that can be scheduled as return on investment. The ratio communicates the annual return that a property will provide.

The NOI should be used to provide insight into the net income that a property can bring in which will inform the decision on whether the investment will be worth the while when compared against the asset value and cost.

Since Total Operating Costs are sometimes unpredictable and may exceed the expected or projected limit, the NOI may fluctuate. This is a shortcoming of the NOI since it may not provide the actual rate of return on investment.

The Cap Rate and Net Operating Income are important to an investor as they give an indication as to the investment they can offer that will reflect the value and return of the property. With the calculations, an investor can have a target Cap Rate in mind that will act as the least return to expect. For instance, an investor can have a Cap Rate of 15% and above which means that the lowest investment to make will be at a 15% return setting. Solving the Net Operating Incomes and Cap Rates will give an investor an idea of what they can comfortably invest depending on the property factors.

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