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# Capitalization rate

Capitalization rate (or "cap rate") is a measure of the ratio between the net operating income produced by an asset (usually real estate) and its capital cost (the original price paid to buy the asset) or alternatively its current market value. The rate is calculated in a simple fashion as follows:

*annual net operating / cost (or value) = Capitalization Rate

For example, if a building is purchased for \$1,000,000 sale price and it produces \$100,000 in positive net operating income (the amount left over after fixed costs and variable costs are subtracted from gross lease income) during one year, then:

*\$100,000 / \$1,000,000 = 0.10 = 10%

The asset's capitalization rate is ten percent.

Capitalization rates are an indirect measure of how fast an investment will pay for itself. In the example above, the purchased building will be fully capitalized (pay for itself) after ten years (100% divided by 10%). If the capitalization rate were 5%, the payback period would be twenty years.Note that in real estate appraisal in the U.S. use net operating income. Cash flow equals net operating income minus debt service. Where sufficiently detailed information is not available, the capitalization rate will be derived or estimated from net operating income to determine cost, value or required annual income.

Use for valuation

In real estate investment, real property is often valued according to projected capitalization rates used as investment criteria. This is done by algebraic manipulation of the formula above:

*Capital Cost (asset price) = Cash flow / Capitalization Rate

For example, in valuing the projected sale price of an apartment building that produces an annual net cash flow of \$10,000, if we set a projected capitalization rate at 7%, then the asset value (or price we would pay to own it) is \$142,857.

This is often referred to as direct capitalization, and is commonly used for valuing income generating property in a real estate appraisal.

One advantage of capitalization rate valuation is that it is separate from a "market-comparables" approach to an appraisal (which compares 3 valuations: what other similar properties have sold for based on a comparison of physical, location and economic characteristics, actual replacement cost to re-build the structure in addition to the cost of the land and capitalization rates). Given the inefficiency of real estate markets, multiple approaches are generally preferred when valuing a real estate asset. Capitalization rates for similar properties, and particularly for "pure" income properties, are usually compared to ensure that estimated revenue is being properly valued.

Cash flow defined

The capitalization rate is calculated using a measure of cash flow called net operating income (NOI), not net income. Generally, NOI is defined as income (earnings) before depreciation and interest expenses:

*Cash flow = Net income + depreciation + interest expense + profit tax - reserves for repairs = Gross income - non-interest expenses

Interest expenses are excluded so that the valuation of the property does not depend on the amount of debt used to purchase the property; in financial terms, the cap rate is a capital structure-neutral valuation measure. Similarly, profit taxes (or other similar taxes) are usually excluded, as they will depend on the interest and depreciation expenses charged; most other taxes, and specifically property taxes, are treated as part of non-interest expenses.

Depreciation in the tax and accounting sense is excluded from the valuation of the asset, as it does not directly affect the cash generated by the asset. To arrive at a more careful and realistic definition, however, estimated annual maintenance expenses or capital expenditures will be included in the non-interest expenses.

Although cash flow is the generally-accepted figure used for calculating cap rates, this is often referred to under various terms, including simply income.

Use for comparison

Capitalization rates, or cap rates, provide a tool for investors to use for roughly valuing a property based on its income. For example, if a real estate investment provides \$160,000 a year in cash flow and similar properties have sold based on 8% cap rates, the subject property can be roughly valued at \$2,000,000 because \$160,000 divided by 8% (0.08) equals \$2,000,000.

Reversionary

Property values based on capitalization rates are calculated on an "in-place" or "passing rent" basis, i.e. given the rental income generated from current tenancy agreements. In addition, a valuer also provides an Estimated Rental Value (ERV). The ERV states the valuer’s opinion as to the open market rent which could reasonably be expected to be achieved on the subject property at the time of valuation.

The difference between the in-place rent and the ERV is the reversionary value of the property. For example, with passing rent of \$160,000, and an ERV of \$200,000, the property is \$40,000 reversionary. Holding the valuers cap rate constant at 8%, we could consider the property as having a current value of \$2,000,000 based on passing rent, or \$2,500,000 based on ERV.

Finally, if the passing rent payable on a property is equivalent to its ERV, it is said to be "Rack Rented".

Change in asset value

The cap rate only recognizes the cash flow a real estate investment produces and not the change in value of the property.

To get the unlevered rate of return on an investment the real estate investor adds (or subtracts) the price change percentage from the cap rate. For example, a property delivering an 8% capitalization, or cap rate, that increases in value by 2% delivers a 10% overall rate of return. The actual realised rate of return will depend on the amount of borrowed funds, or leverage, used to purchase the asset.

In Europe, the term Yield is more frequently used in connection with real estate than capitalization rate. Yield is a more general term that refers to income in relation to the price of an asset.

Recent trends

The National Council of Real Estate Investment Fiduciaries in a Sept 30, 2007 report reported that for the past year, for all properties income return was 5.7% and the appreciation return was 11.1%.

A Wall Street Journal report using data from Real Capital Analytics and Federal Reserve [http://www.wsj.com/article/SB121436232049002445.html?mod=residential_real_estate Capitalization Rates Were Mixed in May, June 25, 2008] showed that since the beginning of 2001 to end of 2007, the cap rate for offices and apartments have dropped from about 10% to 5.5%, and from about 8.5% to 6% respectively. In May 2008, the cap rates 5.98% for the offices and 6.28% for the apartments. By comparison, 10-year treasury yields have remained largely between 4% and 5%.

The cap rates for apartments have been stable at around 6% since late 2005.

ee also

* Real estate investing
* Internal rate of return
* Yield (finance)

* [http://visulate.com/cgi-bin/invest.cgi Visulate Property Investment Worksheet]
* [http://www.forbes.com/fdc/rentorsell.shtml Forbes Cap Rate Calculator]
* [http://www.realtyrates.com/commentaryg.html Historical Cap rate index for several categories of real-estate]
* [http://www.ncreif.com/# Vacancy and Cap rate]

References

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