The Importance of the Capitalization Rate in Real Estate Investing

The capitalization rate is the most commonly used baseline for comparing investment properties. It is analogous to the estimated effective rate of return on security investments. For example, a $100,000 all-cash property with a cap rate of 4.5% will produce the same returns as a $100,000 invested in securities at 4.5%. This figure helps real estate investors determine the best use of their investment funds.

Calculating the Capitalization Rate

A simple formula for calculating the capitalization rate is annual net operating income divided by the market value of a property and it declines as values rise. This formula is the inverse of a standard price/earnings multiple.

Net operating income can be calculated by subtracting from gross revenue all management costs, utilities costs, upkeep, insurance, taxes, and other operating costs. Net operating income does not account for mortgage payments.

Acquisition costs are more than the stated purchase price. They must account for brokerage fees and closing costs. If the property is not rent-ready, all costs incurred for rehabilitation need to be included as well.

Investors must compare capitalization rates that include the same costs. For example, it is invalid to compare one capitalization rate that discounts rent revenues based on average annual vacancies and another that makes no such discount.

Importance of Capitalization Rate

The foremost use of the capitalization rate is to discriminate between different investment opportunities. If a security investment offers an estimated 4% return and a property has a capitalization rate of 8%, an investor is likely to focus on the property.

Real estate investors can use the cap rate to estimate the terminal cap or exit rate of an investment when it is sold at the end of the projected holding period.

Capitalization rates can also indicate trends for commercial property owners. Trends show where the market may head, allowing for adjustments based on estimated rents.

There is a limit to the usefulness of capitalization rates; investment properties with irregular or complicated cash flows can't rely on simple capitalization rates. It would be best to rely on discounted cash flow analysis instead.