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ARTICLE -
What You Need to Know about Capitalization
Rates by
Robert Poe
Cap Rates & Why They
Matter
The
capitalization rate is a measure of rate of
return that relates net income to the value of
the property. If the cap rate is correct for the
market environment, it will attract investors to
the property. The overall capitalization rate
consists of a return on the investment and a
return of the investors money.
To calculate the
capitalization rate, the investor divides the
net income of the property by the value of the
property, arriving at the capitalization rate.
For instance, if you had a $1,000,000 property
with a $100,000 net income, your capitalization
rate would be 10%.
The
capitalization rate, as a stand alone measure of
investment, is useless unless it is compared to
the market capitalization rates for similar
properties. It is a mistake to view a cap rate
on one property as a yardstick of value unless
it is compared to other similar properties. As
an example, if your property has a 10%
capitalization rate and similar properties in
the area are at 6-7%, you need to go back and
re-evaluate your numbers and assumptions. A
lower cap rate usually will indicate a lower
risk property, but not always.
A word of caution
on capitalization rates: when you look at
similar properties, you must be very objective
about the condition, size and location of the
comparison properties. It is useless to compare
a property that is a Class C property to a Class
A property even though they might be in the same
geographical area. In addition, carefully review
the financial statements of the property to
ensure that the net income calculation is
complete and accurate. For instance, be sure to
exclude the principle reduction portion of the
loan payment when you are calculating net
income.
The property size
can influence cap rates. As an example, anything
below four units of a multi-family property will
not benefit from a capitalization rate
calculation. Single family homes used as rentals
should not be subject to capitalization rate
screening as the numbers would be meaningless.
Capitalization
rate calculations are one tool in commercial
real estate analysis. The cap rate should be
bundled with other calculations and cash flow
analysis in order to determine if the subject
property is a suitable addition to your
investment portfolio.
- Submitted by
Robert Poe, CCIM, Certified Short Sale
Professional |
