Capitalization Rate

Capitalization Rate is a ratio used to estimate the value of income producing properties. Investors, lenders and appraisers use the cap rate to estimate the purchase price for different types of income producing properties. Hence, it is decided by buyers and NOT sellers. Theoretically, Cap rate is the larger return expected by buyers when investing in high risk income properties. The Cap rate may vary in different areas of a city for many reasons such as desirability of location, level of crime and general condition of an area. Few things to note about Cap Rate:

• It defines the percentage number used to determine the current value of a property based on estimated future operating income i.e.
Cap Rate = Annual Cash Flow / Value of property

• Capitalization rates are an indirect measure of how fast an investment will pay for itself in net cash flows; each year, the percentage amount of the cap rate will be repaid
i.e. Payback period = 100% / Cap Rate

• In real estate appraisal in the U.S., a stylized measure of cash flow is often used, called net operating income. It is essentially the same as net cash flow, except that debt service and income taxes are not included while a reserve for replacements is included

• One advantage of capitalization rate valuation is that it is separate from a "market-comparables" approach to an appraisal (which only compares what other similar properties have sold for based on a comparison of physical characteristics). Given the inefficiency of real estate markets, multiple approaches are generally preferred when valuing a real estate asset

• Cap rate could be determined based on an appraisal and/or the cap rates of similar properties that have sold recently i.e. by taking another property that sold recently, determining its rental income, divide the income by the sold price to get the cap rate

Thus, if cap rate in a given property increases, the value for that particular property reduces and vice versa.