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Capitalisation Rate (Cap Rate)

Those who invest in real estate via income-producing properties need to have a method to determine the value of a property they're considering buying. One method is capitalisation rate (or "cap rate") which is the ratio between the net operating income produced by a property and its capital cost (the original price paid to buy the property) or alternatively its current market value. The rate is calculated as follows:

  • Capitalisation Rate = which is the ratio between the net operating income / Capital Cost (property price)
  • For example, if a building is purchased for $100,000 and it produces $10,000 net operating income in one year, then:

  • $10,000 / $100,000 = 0.10 or 10%
  • The building's capitalisation rate is 10%. That is, one-tenth of the building's cost is paid by the year's net proceeds so that in 10 years the building will pay for itself.

    Though the capitalisation rate may be used as guide in deciding to purchase an investment property it is subject to periodic revisions. This is because the price of a property and the which is the ratio between the net operating income it generates may fluctuate significantly with time. In the above example, if the property was brought for $100,000 five years ago it may have appreciated in value and now may be sold on the market for $200,000. In such a case the capitalisation rate would be revised to:

  • $10,000 / $200,000 = 0.05 or 5%
  • The building's capitalisation rate is now 5%. That is, one-twentieth of the building's cost is paid by the year's net proceeds so that in 20 years the building will pay for itself.

    The revised capitalisation rate will help the investor decide if it is more profitable (at least in the short-term) to sell property instead of leasing it. The capitalisation rate is a measure of the opportunity cost the investor incurs if he retains the property instead of selling it for potentially $200,000 and investing the money somewhere else.

    Alternatively the value of the property may remain constant but the which is the ratio between the net operating income it generate may rise. For example, the income may increase from $10,000 to $20,000 per annum. Here the capitalisation rate would be revised to:

  • $20,000 / $100,000 = 0.20 or 20%
  • The building's capitalisation rate is now 20%. That is, one-fifth of the building's cost is paid by the year's net proceeds so that in 5 years the building will pay for itself.

    There is an inverse relationship between the property asking price and the the capitalisation rate. That is, the higher the capitalisation rate, the lower the asking price for the property.

    Given the above examples, the capitalisation rate can be, in part, used as guide to purchase and retain a property or alternatively to sell it.

    Related topics:

  • Revenue Multipliers
  • Discounted Cash Flows