# Capitalization rate

Capitalization rate (or "cap rate") is the ratio between the net operating income produced by an asset and its capital cost (the original price paid to buy the asset) or alternatively its current market value.

## Basic formula

The rate is calculated in a simple fashion as follows:

$\mbox{Capitalization Rate} = \frac{\mbox{annual net operating income}}{\mbox{cost (or value)}}$

## Explanatory Examples

For example, if a building is purchased for $1,000,000 sale price and it produces$100,000 in positive net operating income (the amount left over after fixed costs and variable costs is subtracted from gross lease income) during one year, then:

• $100,000 /$1,000,000 = 0.10 = 10%

The asset's capitalization rate is ten percent; one-tenth of the building's cost is paid by the year's net proceeds.

If the owner bought the building twenty years ago for $200,000, his cap rate is •$100,000 / $200,000 = 0.50 = 50%. However, the investor must take into account the opportunity cost of keeping his money tied up in this investment. By keeping this building, he is losing the opportunity of investing$1,000,000 (by selling the building at its market value and investing the proceeds). As shown above, if a building worth a million dollars brings in a net of one hundred thousand dollars a year, then the cap rate is ten percent. The current value of the investment, not the actual initial investment, should be used in the cap rate calculation. Thus, for the owner of the building who bought it twenty years ago for $200,000, the real cap rate is ten percent, not fifty percent, and he has a million dollars invested, not two hundred thousand. As another example of why the current value should be used, consider the case of a building that is given away (as an inheritance or charitable gift). The new owner divides his annual net income by his initial cost, say, •$100,000 (income)/ 0 (cost) = UNDEFINED

Anybody who invests any amount of money at an undefined rate of return very quickly has an undefined percent return on his investment.

From this, we see that as the value of an asset increases, the amount of income it produces should also increase (at the same rate), in order to maintain the cap rate.

## Reversionary

Property values based on capitalization rates are calculated on an "in-place" or "passing rent" basis, i.e. given the rental income generated from current tenancy agreements. In addition, a valuer also provides an Estimated Rental Value (ERV). The ERV states the valuer’s opinion as to the open market rent which could reasonably be expected to be achieved on the subject property at the time of valuation.

The difference between the in-place rent and the ERV is the reversionary value of the property. For example, with passing rent of $160,000, and an ERV of$200,000, the property is $40,000 reversionary. Holding the valuers cap rate constant at 8%, we could consider the property as having a current value of$2,000,000 based on passing rent, or \$2,500,000 based on ERV.

Finally, if the passing rent payable on a property is equivalent to its ERV, it is said to be "Rack Rented".

## Change in asset value

The cap rate only recognizes the cash flow a real estate investment produces and not the change in value of the property.

To get the unlevered rate of return on an investment the real estate investor adds (or subtracts) the price change percentage from the cap rate. For example, a property delivering an 8% capitalization, or cap rate, that increases in value by 2% delivers a 10% overall rate of return. The actual realised rate of return will depend on the amount of borrowed funds, or leverage, used to purchase the asset.

To calculate the change in asset value, divide the appreciation rate by the percent of investor equity in the property. For example, if the property appreciates 3% this year, and I have 25% equity in the property, my profit is .03 / .25 = .12 = 12%.

This appears to use a "relative" percentage rate instead of an "absolute" percentage rate, the latter also known as a "percentage point".

## Recent trends

'The National Council of Real Estate' Investment Fiduciaries in a Sept 30, 2007 report reported that for the prior year, for all properties income return was 5.7% and the appreciation return was 11.1%.

A Wall Street Journal report using data from Real Capital Analytics and Federal Reserve [1] showed that from the beginning of 2001 to end of 2007, the cap rate for offices dropped from about 10% to 5.5%, and for apartments from about 8.5% to 6%. At the peak of the real estate bubble in 2006 and 2007, some deals were done at even lower rates: for instance, New York City's Stuyvesant Town and Peter Cooper Village apartment buildings sold at a cap rate of 3.1% based on highly optimistic assumptions.[2] Most deals at these low rates used a great deal of leverage in an attempt to lift equity returns, generating negative cashflows and refinancing difficulties.[3]

As U.S. real estate sale prices have declined faster than rents due to the economic crisis, cap rates have returned to higher levels: as of December 2009, to 8.8% for office buildings in central business districts and 7.36% for apartment buildings.[4]