Capitalization rate is a concept in the real estate industry that many people fail to understand. There is no better way to boost your understanding of the subject matter than to start with the basics. Let’s begin our discussion.
What is Capitalization Rate?
Capitalization rate, often referred to as cap rate, is a fundamental concept that is used in the commercial real estate business. By definition, cap rate pertains to the expected rate of return on an investment property that is based on the income generated. Simply put, it is used to estimate the investor’s potential ROI.
It can be calculated by dividing the Net Operating Income by the Current Market Value of the property.
- Net Operating Income (NOI)
This is a valuation method used to determine the value of income properties. To compute the net operating income, subtract the operating expenses from the property income.
- Current Market Value (CMV)
Refers to the most recent market price for listed securities.
Here’s the formula to better illustrate the concept.
Cap Rate = Net Operating Income/Current Market Value
To give you a better picture of how cap rate is calculated, here is an example. If a property has a current market value of $2 million and has a net operating income of $100,000, the cap rate would be 20%.
20% = $100,000 / $ 2,000,000
Here’s another example. Suppose a property has a stabilized net operating income of $1 million, and sales value of $23 million, the property will be sold at a 4.35% cap rate.
4.35% = $1,000,000 / $23,000,000
When Should You Use a Cap Rate?
Capitalization rate can be useful in several scenarios in the commercial real estate industry.
- Use it to quickly size up the return on investment on a particular property compared to other potential investment properties in a similar location.
- Use cap rate trends to indicate where the real estate market is headed.
What Factors Affect the Cap Rate?
Many factors can affect the cap rate of real estate properties. Among these factors are:
- age of the property;
- diversity and creditworthiness of the tenants;
- supply and demand in the market; and
- underlying economic fundamentals, such as employment and population growth, among others.
Understanding capitalization rate can be a tricky business especially if you lack understanding of its basic concepts. If you want to learn more about cap rate and other concepts about the construction industry, be sure to stay up-to-date with the latest from the construction giants, such as the ENM Construction Management spearheaded by Dan Greenhalgh and Colin Lacey. These two have been in the construction industry for years now, and they can surely help you with your quest for knowledge!