How Is Capitalization Rate Used By Real Estate Investors?

Capitalization rates measure cash returns from investment properties.

The capitalization rate is a measure of the return that a real estate investment provides relative to its price or value. Investors derive it by dividing a property's Net Operating Income (NOI), which consists of a year's worth of recurring income reduced by non-capital expenses, by its purchase price or value. In many areas of investment real estate, it is more important than other, more traditional metrics, like cost per square foot because it measures a property's unleveraged cash flow, which, to many investors, is more important than the cost of the actual building.

Valuing Owned Property

One of the most basic uses of the capitalization rate is to calculate the value of your property at any given time. To do this, you simply need to compute your NOI, and divide it by a market capitalization rate. For instance, if your property has an NOI of $250,000 and the market capitalization rate is 8.5 percent, dividing 250,000 by 0.085 would yield a value of just a little over $2,940,000. You can also use this to track changes in your property's value by simply taking the NOI at various points in time and dividing it by the capitalization rate that applied at those times.

Analyzing Comparable Sales

Because relatively few investment properties change hands in a given time period, and because they tend to be quite different from each other, analyzing capitalization rates is an excellent way to understand the market. For instance, imagine three small retail centers located in different neighborhoods with different architectural styles, tenancies, and sizes. Over the course of the year, they may have sold for prices ranging from $1,500,000 to $3,000,000 and prices of anywhere from $120 to $180 per square foot. Comparing buildings or even square foot prices to find a conclusion would be almost impossible, but if you know that they traded in a range from a 9.0 to 9.2 percent capitalization rate, you would see that the actual value of the income from a small retail center is very narrowly defined.

Comparative Return Analysis

The cap rate is an intermediate step to understanding how a building will perform. Once you understand its cap rate, you can look at its actual return. The first step when looking at an investment is to determine whether it can be positively or negatively leveraged. If the cap rate is lower than prevailing interest rates, unless you have an extremely good reason to buy the property, it is probably not a good investment, since it makes no sense to take on the risk of ownership for a lower return than the person who is just lending the money to buy it. If the cap rate is above prevailing interest rates, it indicates that not only is the asset potentially priced reasonably, but also that you have the potential to enjoy meaningful cash flow.

Improvement Feasibility Studies

Cap rates are also useful tools for investors who need to decide whether or not to make improvements or developments. For instance, consider an owner of a small, 20-unit apartment building who is trying to decide whether to spend $3,000 per unit to renovate the kitchens, to be able to raise rents by $30 per month. Since a portion of the increase would go to ongoing expenses, like an increased management fee, his NOI would go up by about $325 per year. At an 8 percent cap, that $325 in additional NOI would be worth over $4,000 per unit (325 / .08). With this in mind, the improvement makes sense.

Development Feasibility Studies

Developers also do this on a larger scale when they decide to build a building. They know what it will cost them to develop the building, and can project what income it will generate. With that information, they can divide the projected NOI by their projected market cap at the time they sell the building. If the calculated price is greater than what it will cost them to buy the land, build the building and carry it until its sale, the development is worth doing. If not, they do not move forward.