Capitalization rate is an important concept of real estate investing. It is very common for newbies to misinterpret the concept or use it inappropriately. This article is intended to resolve that problem by providing an insight into what capitalization rate is, how it is calculated and how it is used.

Often referred to as Cap Rate, Capitalization Rate is the ratio of Net Operating Income (NOI) to the asset value of a property. In other words, a Cap rate is the ratio between the NOI an asset produces and the original capital cost. For example, if a residential building was listed for $2,000,000 and same generated a Net Operating Income (NOI) of $200,000 then the Cap Rate will be calculated as $200,000/$2,000,000 = 0.10 = 10%

What is a Net Operating income (NOI)?

Net Operating income is the annual income that an income producing property generates after deducting all the expenses incurred during operations from all income collected during operations. It is very easy to understand Net Operating Income. Net Operating Income is considered positive when operating income is higher than operating expenses and negative when operating expenses is higher than operating income. The essence of NOI is to measure the ability of a property/asset to produce an income stream from operation.

Example of Cap Rate
For example, if we are researching the sale of an office complex in Chicago, Illinois with a NOI of $500,000 and a sale price of $7,000,000 in the commercial real estate industry to calculate the Cap rate of this office complex, the formula is : Annual Net Operating Income / Cost or Value of the Building. In this instance, it would be said that the Cap Rate at which the building was sold is 7.1%.

The intuition behind Cap rate is that it represents the percentage return an investor would receive on cash purchases. In the example above the implication of the cap rate is that for that particular building, an investment of $7,000,000 would yield an annual return of 7.1%

Cap Rate Vs Cash on Cash Return

The difference between Cap Rate and Cash on Cash Return is that a Cap Rate compares the purchase price at which a property was acquired to the income it generates. On the other hand, the Cash on Cash Return calculates how much money accrues on the actual investment made. In terms of determining the actual returns on your investment, what you focus on is the Cash on Cash Return.

When to use (and when not to) the Cap Rate

The Cap rate is very popular in the real estate industry. It can be very helpful in several scenarios. For example, when an Investor is considering the best option in several possible property acquisitions, the Cap Rate could be quickly used to determine which will be the best option. Another way a Cap rate can be helpful is when they form a trend. When you are looking at a Cap rate trend for like a few years, then the trend can provide an indication of where the real estate market in that location is headed. However there are times when relying on a Cap rate for a property acquisition can destroy an investor.

This example will provide a typical instance of when it will be fatal to use Cap Rate. It is the story of an investor who purchased a multifamily home that had four bedroom units. However, the property was located close to a University Community hence the real estate around the area was saturated by demands from students. The investor who bought the multifamily home immediately cleaned up the property and decided to cash in on the very high student demand for rooms to rent. Rather than rent out the house to an individual, he rented it out by the bedroom, one bedroom to one tenant.

The consequence of this is that the property generated higher revenues. The house generated a higher revenue of 40% due to the fact that it was rented out by the bedroom. The property was eventually sold to an Institutional Investor who had no idea that the Cap Rate of the building appeared on the high side but did not know that the property was being rented out on a one bedroom to one individual basis. The purchaser paid the purchase price for the home on the basis of the Cap Rate it produced and in the long run rented out the entire four bedroom unit to just one individual. The consequence of this is that the initial 40% increase in revenue generated by the home collapsed the moment the house became rented by a single Individual as a single unit. The lesson to learn from this incidence is that it is not at all times that an Investor should rely on the Cap Rate to determine if a property is worth investing in.

How to arrive at an accurate Cap Rate:

Big wigs in the real estate industry do not joke with the factors that needs to be considered to get an accurate Cap rate. They are as follows:

1. Use recent data from the area a property is located to determine the property’s value:
To get an accurate Cap Rate then the actual value of the property must first be determined. If you improperly assign value to a property, you can be certain that the cap rate will be wrong. When you are about to purchase a property, review recent data from the area the property is located in order to ensure that the value you assign to the property is the actual worth of the property. When you arrive at an actual worth of a property, whatever cap rate that you derive therefrom can be reliable.

2. Project future rent with rental rate history:
On the income side of your calculation of cap rate, the projected future rent of the property must be determined. When you overestimate future rent then you will arrive at a wrong cap rate.

3. Include all expenses when calculating NOI:
Another reason why your cap rate may be wrong is if you fail to include all expenses in the calculation of your Net Operating Income. This will produce an unreliable cap rate.