What is the capitalization rate?
The capitalization rate (also called the ceiling rate) is used in the world of commercial real estate to indicate the rate of return that should be generated on a real estate investment property. This measure is calculated on the basis of the net income that the property should generate and is calculated by dividing the net operating profit by the value of the real estate assets and is expressed as a percentage. It is used to estimate the potential return of the investor on his investment in the real estate market.
Although the ceiling rate can be useful for quickly comparing the relative value of similar real estate investments in the market, it should not be used as the only indicator of the strength of an investment as it does not take into account the effect of leverage, the time value of money and future cash flows from property improvements, among other factors. There is no clear range for a good or a bad ceiling and they largely depend on the context of the property and the market.
Key points to remember
- The capitalization rate is calculated by dividing the net operating profit of a building by the current market value.
- This ratio, expressed as a percentage, is an estimate of the potential return of an investor on a real estate investment.
- The ceiling rate is most useful for comparing the relative value of similar real estate investments.
Understanding the capitalization rate
The ceiling rate is the most popular measure by which real estate investments are assessed for their profitability and potential return. The cap rate simply represents the return on a property over a one-year horizon assuming the property is purchased in cash and not on loan. The capitalization rate indicates the intrinsic, natural and leverage-free rate of return on the property.
Capitalization rate formula
Several versions exist for calculating the capitalization rate. In the most popular formula, the capitalization rate of a real estate investment is calculated by dividing the net operating income (NOI) of the building by the current market value. Mathematically,
Capitalization rate = net operating profit / current market value
Net operating profit is the (expected) annual income generated by the property (such as rentals) and is obtained by deducting all expenses incurred for the management of the property. These expenses include the cost paid for regular maintenance of the facility as well as property taxes.
The current market value of the asset is the current value of the property at prevailing market rates.
In another version, the figure is calculated based on the original capital cost or the cost of acquiring a property.
Capitalization rate = net operating profit / purchase price
However, the second version is not very popular for two reasons. First, it gives unrealistic results for old properties that were bought several years / decades ago at low prices, and second, it cannot be applied to the inherited property because their purchase price is zero, which makes division impossible.
In addition, since real estate prices fluctuate considerably, the first version using the current market price is a more accurate representation compared to the second version using the original purchase price with fixed value.
Examples of capitalization rates
Suppose an investor has a million dollars and plans to invest in one of two investment options available – one, he can invest in government-issued treasury bills that offer interest nominal annual of 3% and are considered the safest investments and two, he can buy a commercial building with several tenants who should pay regular rent.
In the second case, suppose that the total rent received per year is $ 90,000 and that the investor has to pay a total of $ 20,000 for various maintenance costs and property taxes. This leaves the net income from property investment at $ 70,000. Suppose that during the first year, the value of the property remains stable at the initial purchase price of $ 1 million.
The capitalization rate will be calculated as follows: (net operating profit / property value) = $ 70,000 / $ 1 million = 7%.
This return of 7% generated by real estate investment is better than the standard return of 3% available on risk-free Treasury bills. The additional 4 percent represents the risk return taken by the investor in investing in the real estate market compared to investing in the safest Treasury bonds that carry zero risk.
Real estate investment is risky, and there can be several scenarios where the return, as represented by the capitalization rate measure, can vary considerably.
For example, some of the tenants may move out and the rental income from the property may decrease to $ 40,000. By reducing the $ 20,000 towards various maintenance costs and property taxes, and assuming that the value of the property remains at $ 1 million, the capitalization rate is set at ($ 20,000 / $ 1 million) = 2 %. This value is lower than the available yield of risk-free bonds.
In another scenario, suppose that the rental income remains at $ 90,000, but that the maintenance costs and / or the property tax increase considerably, that is, $ 50,000. The capitalization rate will then be ($ 40,000 / $ 1 million) = 4%.
In another case, if the current market value of the property itself decreases, or $ 800,000, with the rental income and the various costs remaining the same, the capitalization rate will increase to $ 70,000 / $ 800,000 = 8.75 %.
Essentially, the different levels of income generated by the property, the expenses related to the property and the current market valuation of the property can significantly change the capitalization rate.
The excess return, which is theoretically available to real estate investors beyond investments in treasury bills, can be attributed to the associated risks that lead to the above scenarios. Risk factors include:
- Age, location and status of the property
- Type of property – multifamily, office, industrial, retail or recreational
- Creditworthiness of tenants and regular rental payments
- Duration and structure of the tenant’s lease (s)
- The overall market rate of the property and the factors affecting its valuation
- Macroeconomic fundamentals of the region as well as factors impacting tenant activities
Interpretation of the capitalization rate
Since the ceiling rates are based on projected estimates of future income, they are subject to wide variations. It then becomes important to understand what constitutes a good capitalization rate for an investment property.
The rate also indicates the time it will take to recover the amount invested in a property. For example, a property with a 10% ceiling rate will take approximately 10 years to recoup the investment.
Different cap rates between different properties, or different cap rates over different time horizons on the same property, represent different levels of risk. A review of the formula indicates that the value of the cap rate will be higher for properties that generate higher net operating income and have a lower valuation, and vice versa.
Say, there are two properties that are similar in all attributes, except that they are geographically distinct. One is in an upscale downtown area while the other is on the outskirts of town. All else being equal, the first property will generate higher rent than the second, but these will be partially offset by the higher maintenance cost and higher taxes. The downtown property will have a relatively lower capitalization rate than the latter due to its significantly high market value.
It indicates that a lower value of the ceiling rate corresponds to a better valuation and a better prospect of return with a lower level of risk. On the other hand, a higher capitalization value implies relatively lower prospects for return on real estate investment, and therefore a higher level of risk.
While the hypothetical example above allows an investor to easily choose property in the city center, the actual scenarios may not be as simple. The investor who assesses a property on the basis of the ceiling rate faces the difficult task of determining the appropriate ceiling rate for a given level of risk.
Representation of the Gordon model for the ceiling rate
Another representation of the ceiling rate comes from the Gordon growth model, which is also called the dividend discount model (DDM). It is a method of calculating the intrinsic value of a company’s share price regardless of current market conditions, and the value of shares is calculated as the present value of future dividends on a share. Mathematically,
Share value = expected annual dividend cash flow / (rate of return required by the investor – expected dividend growth rate)
Reorganize the equation and generalize the formula beyond the dividend,
(Rate of return required – Rate of growth expected) = Cash flow / asset value expected
The above representation corresponds to the basic formula of the capitalization rate mentioned in the previous section. The expected value of cash flows represents the net operating income and the value of the assets corresponds to the current market price of the building. This leads to a capitalization rate equivalent to the difference between the required rate of return and the expected rate of growth. In other words, the ceiling rate is simply the required rate of return minus the growth rate.
This can be used to assess the valuation of a property for a given rate of return expected by the investor. For example, suppose that the net operating income of a property is $ 50,000 and that it should increase by 2% per year. If the expected rate of return of the investor is 10% per year, the net ceiling rate will reach (10% – 2%) = 8%. Using it in the above formula, the valuation of the assets is ($ 50,000 / 8%) = $ 625,000.