What Does Capitalization Rate Mean?

••• office building image by John Sandoy from Fotolia.com

Capitalization rates, or cap rates, are an important part of valuing investment property. They are widely used by real estate investors, brokers and financial institutions in gauging a property’s value based on market information. Similar to P/E ratios in the stock market, cap rates are a guide to measuring a property’s value relative to its income. Using cap rates properly is key to successful real estate investing.

The Capitalization Rate Formula

A property’s cap rate equals its projected next-year net operating income divided by its value. Net operating income, or NOI, equals gross income minus operating expenses. For example, a property with a $10,000 NOI and a $100,000 market value has a 10 percent cap rate. Value is also estimated by manipulating the formula. Value equals NOI divided by cap rate. This valuation estimate is called the direct capitalization method. NOI can also be estimated. NOI equals value times cap rate.

Uses

Capitalization rates provide a rough estimate of the rate of return on a property if it were purchased with all cash and no debt. Comparable income properties of the same type typically sell for similar cap rates in the same market. Using cap rates from recently sold, comparable properties, an investor can estimate the value of a similar property. Using the cap rate formula is a common way for investors and brokers to estimate a property’s value without making detailed forecasts of a property’s future cash flows.

Changes in Cap Rates

Cap rates reveal an investor's sentiment in real estate markets based on the prices he's paying for properties. Increasing and decreasing cap rate trends help alert an investor to changing market conditions. Because cap rates are inversely related to value, cap rates decrease when prices rise due to favorable economic conditions. Cap rates increase when prices fall due to an uncertain economy as investors require a higher rate of return.

Limitations

Because cap rates are determined using the forecasted NOI for only the next year, the cap rate formula doesn’t consider changes that may occur in subsequent years. For example, the cap rate formula wouldn’t reveal an expected increase in rents in two years. Another aspect missing from the cap rate formula is the time value of money. Using the direct capitalization method to estimate a property’s value fails to account for the overall return an investor receives from future cash flows.

References

Photo Credits

  • office building image by John Sandoy from Fotolia.com