'Cap Rate' is explained in detail and with examples in the Corporate Finance edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Cap rate refers to the real estate property and its rate of return. Investors figure this out by utilizing the income which they anticipate the property will generate. The cap rate is also referred to as the capitalization rate. Realtors utilize it to gauge how much return investors will realize on their investments.
The way people determine this cap rate is by using an easy to understand formula. Investors take the property’s NOI net operating income and divide it by the current fair market value of the property. This NOI turns out to be the annual return less all operating costs. The capitalization rate formula can be written as Capitalization Rate = Net Operating Income / Current Market Value. Investors and realtors express it as a percentage.
Investors consider the cap rate to be very helpful because it summarizes information regarding real estate investments. It is also simple to understand. This important rate discerns the profitability of a given piece of property. In order for it to remain consistent, the net operating income and current market value have to be constant compared to each other. If the NOI goes up when market value remains constant, the capitalization rate rises. If instead market value increases while NOI remains the same, then this rate will go down.
Real estate investments only stay profitable if the NOI goes up at the same rate as or a greater rate than the increase in the value of the property. This is another way that the capitalization rate is helpful. It can be employed to track the performance of real estate investments through time to learn if their performance is increasing. When the rate declines instead, investors may decide to sell the property so that they can reinvest the capital in some other place.
The cap rate is especially practical because it allows individuals to measure different investments in property. It permits them to compare and contrast a number of different investment possibilities against each other. Sometimes it is not easy to compare operating income or market values of radically different properties. Comparing percentages to one another is simple and intuitive. The rate is at its most useful when either the current market value or NOI are similar. This is because investments where the cost is vastly different can create a variety of other considerations that interfere with effective comparison.
Many times investors will come up with a minimum capitalization rate which they are willing to take so that the investment is practical. They might set 12% as their minimum rate. This helps them to sift through the various possibilities to rule out the ones that do not measure up to their desired minimum.
Investors may also employ the capitalization rate to figure out the amount of time it will take for the investment to reach its payback point. They can find the payback period by taking 100 and dividing it by the capitalization rate. This will provide an estimate of the payback period and not a fixed number. Most investments will see their capitalization rate change during significant amounts of time.
Another useful way of determining the value for a real estate investment is to utilize direct capitalization. To find this number, investors simply divide their NOI by the cap rate. This provides them with the capital cost of the real estate investment in question.
Investors should realize that the capitalization rate is not so helpful for shorter time frame investments as it is for longer ones. Figuring up NOI requires some time to determine a cash flow number that is reliable.