Capitalization Rate - Explanatory Examples

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 are 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.

Capitalization rates are an indirect measure of how fast an investment will pay for itself. In the example above, the purchased building will be fully capitalized (pay for itself) after ten years (100% divided by 10%). If the capitalization rate were 5%, the payback period would be twenty years. Note that a real estate appraisal in the U.S. uses net operating income. Cash flow equals net operating income minus debt service. Where sufficiently detailed information is not available, the capitalization rate will be derived or estimated from net operating income to determine cost, value or required annual income. An investor views his money as a "capital asset". As such, he expects his money to produce more money. Taking into account risk and how much interest is available on investments in other assets, an investor arrives at a personal rate of return he expects from his money. This is the cap rate he expects. If an apartment building is offered to him for $100,000, and he expects to make at least 8 percent on his real estate investments, then he would multiply the $100,000 investment by 8% and determine that if the apartments will generate $8000, or more, a year, after operating expenses, then the apartment building is a viable investment to pursue.