Reviewed by Aug 27, 2020| Updated on
In the commercial real estate world, the capitalisation rate (also known as cap rate) is used to denote the rate of return expected to be created on immovable property. This calculation is determined on the basis of the net income that the property is anticipated to generate and is computed by dividing net operating income by asset value of the property and expressed in a percentage. It is used to measure the potential return on the investor's investment in the real estate market.
While the cap rate can be useful to quickly compare the relative value of comparable market real estate investments, it should not be used as the sole measure of the quality of an investment. This is because it does not take into account the leverage, the time value of capital and potential cash flows from property upgrades, among other factors. There are no clear ranges for a good or poor cap rate, and they depend primarily on the real estate background and the economy.
Formula for Capitalisation Rate
There are many variations for the capitalisation rate calculation. The capitalisation rate of a real estate investment is determined by:
Capitalisation Rate = Net Operating Income / Current Market Value
In another variant, the figure is determined using the original cost of capital or the cost of purchasing a land.
Capitalisation Rate = Net Operating Income / Purchase Price
Nevertheless, there are two reasons why the second version is not very popular. Firstly, it provides unfair results for old assets that were bought at low prices many years/decades ago. Secondly, it cannot be extended to the inherited property because their purchase price is zero, which makes the division impossible.
Given that property values fluctuate widely, the first variant that uses the current market price is a more reliable representation compared to the second one that uses the initial selling price of the fixed value.
Interpretation of Capitalisation Rate
Since cap levels are based on the estimated future income projections, they are subject to high variances. Comprehending what constitutes a reasonable cap rate for an investment property is relevant then.
The rate also reflects the period of time it will take to recover the amount invested in an estate. For example, it would take around ten years for a property with a cap rate of 10 per cent to recover the investment.
Different cap rates across different assets or different cap rates on the same property over different time horizons reflect different levels of risk. The formula shows that for properties which produce higher net operating income and have a lower valuation, the cap rate value would be higher, and vice versa.