Rate Measure

Capitalization Rates and How They Work

A capitalization rate is a measure commonly used in real estate investment especially in the acquisition of income properties. The rate measures return on investment and allows the investor to compare various forms of investment in order to decide where he is going to put his money. It is one of the most misunderstood and misused tools in the area of investment analysis so let us take a little time to understand both the importance and the limitations of using capitalization rates.

In its most basic form, capitalization rate is defined as the ratio of the net operating income generated by an asset to its acquisition cost or the current market value For example, if I buy a house for $100,000 and my net operating income (NOI is defined as the amount that is left over after costs are deducted from gross rental income) is $10,000, my capitalization rate or "cap rate" as it is commonly referred to is 10%. Current market value is often used in the cancelation instead of acquisition cost especially in the case of assets bought some years ago. The reason is evident. In our example, if the house I bought for $100,000 is worth $500,000 now, the real cap rate is 2% and not 10%. This is because I could sell the house for $500,000 and have the money to invest elsewhere so I must measure the return against $500,000 and not against $100,000. In other words, any alternate form of investment that gives me a return of more than 2% is superior provided the risk is similar.

Another way of looking at the capitalization rate is called payback. Payback refers machine to the. Timeframe in which I can recover my investment. For instance in our above example, at a cap rate of 10%, my payback is 10 years. In other words I would recover my investment of $100,000 in a period of 10 years. If the cap rate were 20%, my payback would be five years.

We are now ready to use our knowledge of capitalization rates in the evaluation of income properties for investment. As we know, the equation is capitalization rate equals NOI divided by capital cost. Using elementary algebra, if we know the values of two of these, we can calculate the third. For instance, if you are offered a property which generates NOI of $10,000, and your second capitalization rate is 10%, you would buy the property if it was offered to you for $100,000 or less but you would not pay a cent more than $100,000. Similarly if you were offered a property for $100,000, you would expect to see and an NOI of at least $10,000 at a capitalization rate of 10%. You could also use cap rate to choose between investments with a similar risk profile. On the other hand, if you were offered two investments the same capitalization rate but differing risk, prudence would take that you chose a lower risk option.

A major drawback of using capitalization rates is that because of the way NOI is computed, the method is indifferent as to whether you use equity or debt for the investment and the relative proportion of the two. In reality, you are using debt; you would expect to factor in debt costs into your calculation to evaluate your true return on your investment.

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