In the context of real estate, capitalization rates (cap rates) measure the estimated rate of return for income-generating properties, such as commercial buildings, industrial spaces, and residential multifamily units.
They are calculated by dividing the net operating income (NOI) by its current market value.
Real estate investors often use capitalization rates to compare multiple investment opportunities and choose the one that best suits their risk and reward preferences.
As a real estate investor, you rely on profitability metrics to make informed decisions about which properties to buy and when. For investment properties that generate stable income, such as commercial buildings or multifamily developments, cap rates are a key measure of profitability.
Capitalization rates can be used to quickly compare one investment opportunity to another, allowing you to choose confidently among multiple options.
What is a capitalization rate?
It is a profitability measure used to assess the potential rate of return on an income-generating investment property. These rates reflect a property's net operating income (NOI) as a percentage of its value. This rate of return is for a single year of operation and does not consider the financial impact of any existing loans on the property or changes in future cash flows due to future improvements.
Why are they important in real estate investment?
They are essential because they help investors assess potential returns, compare properties, and evaluate investment risks.
Capitalization rates are often used to compare the relative value of multiple properties, particularly those located in the same area or market segment, so that an investor can decide among multiple opportunities. A higher capitalization rate generally indicates greater risks and potential rewards, while a lower capitalization rate suggests lower risks and potential rewards.
When should capitalization rates be used (and when should they not)?
Capitalization rates are most useful for properties with a history of continuous income generation. Well-established shopping centers, for example, are often good candidates for capitalization rate calculations, particularly when they have multiple long-term tenants and relatively low vacancy rates.
Capitalization rates don't work well for properties that generate sporadic income. Short-term vacation rentals, for example, typically experience seasonal fluctuations, longer vacancy periods, and greater price volatility than long-term residential rentals. The income generated by vacation rentals may not be stable enough for capitalization rate calculations to be useful.
How do capitalization rates differ from return on investment (ROI)?
Capitalization rates and ROI are similar in that they both measure potential returns. However, while capitalization rates don't account for financing, ROI does. Capitalization rates are useful for comparing assets to see which has better potential. ROI is better at determining the actual return received for each dollar invested over time.
How are capitalization rates calculated?
To calculate a property's capitalization rate, divide the NOI by its current market value. Then, multiply the result by 100 to convert it to a percentage.
Steps to calculate the capitalization rate
The capitalization rate formula can be divided into three steps:
Step 1: Calculate the NOI of the property
Net Income (NOI) is the property's total annual income minus its total annual expenses. Income includes rental income, as well as additional income from services such as paid parking or laundry. Expenses include property taxes, insurance premiums, maintenance, repairs, and vacancy losses. It's important to note that any mortgage (principal and interest) is not included in capitalization rate calculations.
Step 2: Divide the NOI by the current market value of the property
The current market value can be determined with a formal appraisal or a less formal broker's opinion of value (BOV). If the property was recently sold, the sale price can be an accurate indicator of its value.
Divide the NOI calculated in Step 1 by the current market value.
Step 3: Convert to a percentage
In the final step, the result is multiplied by 100 to convert the result into a percentage.
Factors that can affect capitalization rates
Multiple factors can affect capitalization rates, including:
- Location : Properties in high-demand areas, such as major cities or shopping centers, generally have lower capitalization rates because they are considered safer investments.
- Interest rates : Rising interest rates typically lead to higher compounding rates. This is because higher interest rates make borrowing more expensive, which can reduce the amount investors are willing to pay for properties.
- Property type : Some property types carry more risk than others. This can vary depending on the market, but as a general example, retail spaces are riskier than residential properties.
- Property status: Older structures with overdue maintenance could have higher capitalization rates due to higher maintenance costs.
- Rent control laws: In markets with strict rent controls, capitalization rates could be high due to limitations on potential income.
Source: https://www.pnc.com/insights
