- Capitalization Rate = Net Operating Income / Current Market Value
The current market value of the asset is the present-day value of the property based on market rates, also known as the fair market value. Basically, it’s what you could sell the property for today.
Cap rates can also be calculated based on the original or acquisition cost of the property—net operating income divided by the purchase price—although this version is not very popular. Firstly, it gives unrealistic results for old properties that were purchased several years or decades ago at low prices. Secondly, it cannot be applied to the inherited property as their purchase price is zero, making the division impossible.
Additionally, since property prices can fluctuate widely, the first version that uses the current market price is a more accurate representation as compared to the second one.
Cap rates can also allow commercial property owners to analyze trends. Trends can show where the market may head, allowing for adjustments based on estimated rents. There is a limit to their usefulness, however: Investment properties with irregular or complicated cash flows can’t rely on simple capitalization rates. In the case of irregular cash flows, other return metrics or methods might be best used, such as a discounted cash flow (DCF) analysis.
Comparing the cap rate to the dividend discount model, the expected dividend and cash flow value represents the net operating income. The stock or asset value is akin to the current market price of a piece of property. Thus, the cap rate is similar to the difference between the required rate of return and expected growth rate. With this, investors can more easily compare other investment opportunities, such as stocks, with that of rental property ownership.
Consider an apartment building with an annual NOI of $75,000 and an expected 2.5 percent increase in NOI expected yearly. The investor has a required rate of return of 10 percent, which means their cap rate would be 7.5 percent. Using the DDM, the property’s value would then be $100,000.
In addition to cap rate and DCF analysis, there are other baseline formulas and metrics real estate investors, notably commercial real estate investors, should familiarize themselves with when analyzing investments. For instance, there’s cash-on-cash return, internal rate of return and return on investment that can be used when valuing a property.
For those who are familiar with finance but new to real estate, a cap rate is the reverse of the price-to-earnings (P/E) ratio used in the stock market. While the P/E ratio measures the price, or market value, of a stock divided by its earnings per share, the cap rate measures the annual net operating income of a property, divided by its value. Like the P/E ratio, if there is no income—i.e. the property is not an income producer—then the cap rate cannot be found.
With more capital flowing to real estate while the supply of property investments tends to stay rather constant, investors are forced to bid up prices. Assuming property NOIs remain rather steady, higher interest rates tend to force capitalization rates lower.