Capitalization Rate Explained

Every time I mention a capitalization rate to a group of learning based, future investors, I get this blank deer in the headlights’ look (not that I have stared many deer in the face). So I decided to simplify the meaning and amplify the importance.

The capitalization rate(R) is the rate of return used to estimate the property’s value based on that property’s net operating income. Often called a Cap Rate (Rate), it is the method for determining the attractiveness of the investment for the potential purchaser.

First one needs to understand net operating income (NOI). The net operating income is the annual income minus all expenses. Expenses would include taxes, insurance, management fees, homeowner’s insurance, common area utilities and any other expenses that is paid toward running this particular piece of real estate. It does not include the mortgage… never. This rate of return assumes that the property was paid for with cash. Therefore, when you see income on this formula, we are talking about the net operating income, or, NOI which we will use the single letter I to designate. 

Income capitalizationis the market valuation of a property based upon a one-year projection of income. Stabilized NOI(I) is the true earning potential of the property in the absence of undue or extraordinary circumstances albeit its yearly history which is repetitive. In other words, it relies on a single year’s stabilized NOI to estimate the value of a property.

It may help to think of the IRV formula in the form of a triangle. It is the income capitalization method real estate managers or appraisers use. The key elements in this formula are the stabilized NOI (I) and the capitalization rate (R) and the value (V).

Cover up one letter at a time:

I = Rate (cap) X V (Value)

R = income/value

V = income / rate

Let’s look at some examples:

If, for example, we know the Net Operating Income (NOI) is $100,000 and we want a 10 CAP you would take the top of the pyramid (I) and divide it by the R (CAP).

I (NOI) is $100,000 /R (CAP) is 10%= V (Value) is $1,000,000

Lets look at another scenario where we are told a building is selling for $1,000,000 and at a 8 CAP, here is how we would quickly see how much income is being generated.

I = $1,000,000(V) X .08 = $80,000 NOI

Investors often use cap rate analysis in determining offer amount on income property. If a seller is asking $600,000 for a building, Is it a good deal? The income is $5000 per month. Taxes are $2700 per year. Insurance is $600 per year, and there is an 8% management fee.

$5000 x 12 months =$60,000 Income per year
$60,000 X .08 management = $4800 per year
Annual Expenses $2700 + $600 + $4800 = $5400
$60,000 – $5400 = $54,600 = I for NOI
I $54,000 / V $600,000 = 9 % R Cap Rate. Yes, It is a good deal!

If, however, the buyer decides to offer $500,000 on the last scenario:

I $54,000 / V $500,000= 10.8% R Cap Rate It is an even better deal!

As one lowers the Value or price offered, the R cap rate goes up. They are inversely proportioned. Also, as one increases the rental Income, the R cap ate will increase.

Different properties trade at different cap rates based on risk or lack thereof. A CVS drug store is going to be there for 20 years and you will collect rent exactly on time (low risk also called coupon clipper), so it would sell at a 5% or 6% cap rate. Rental houses in town where you will have to replace tenants periodically and do maintenance may trade at an 8-9% Rate because of higher risk. When the economy was down, these same houses traded at a 15% cap. So, cap rate will vary on the state of the economy as well.

In summary, the capitalization rate (R) is the rate of return used to estimate the property’s value based on that property’s net operating income. The cap rate is the method for determining the attractiveness of the investment for the potential new owner. Hopefully, this will help you judge your income properties.