Capitalization Rate

Capitalization Rate Definition

The accepted capitalization rate definition is a ratio between the annual net operating income produced by an asset and either the total cost of its initial acquisition for new properties or its current value for properties already owned by the investor. Generally, this ratio is applied to real property in order to determine potential earnings and return on investment. Capitalization rates, also known as cap rates, provide investors with a quick method for comparing the desirability of different properties for purchase or assessing the advisability of retaining a property or selling it and using the money for a different investment opportunity.

Capitalization Rate Formula

The formula for calculating the capitalization rate of an investment is expressed as:

• Annual Net Operating Income / Initial Cost or Current Value of Investment = Capitalization Rate

Net operating income is defined as the net earnings of a property before depreciation and interest expenses are figured. For new investments, the initial cost is considered to be the fair market value. For existing investments, the current market value should be used, as it will give a more accurate resulting figure.

For example, if a company purchases a building at a cost of $10,000 with the expectation that it will produce $1,000 per year in net profit, then the capitalization rate for that investment would be 10 percent. However, if the building increases in value over time to $20,000 while income remains steady at $1,000, then the overall capitalization rate is $1,000 divided by $20,000, or five percent. As can be seen, appreciation of real property often results in a lower capitalization rate, and may trigger the sale of the property in question in order to reinvest the proceedings in other opportunities.

Market Capitalization Rate

The same principles are used for market securities as for real estate in calculating the capitalization rate. However, due to the volatility of securities, the current value is always used in figuring the market capitalization rate; the initial purchase price is unlikely to reflect the current value accurately. Additionally, due to that same volatility, the capitalization rate is usually applied retroactively to securities to provide a historical basis for comparison between two or more investments.

The initial cost of the investment should only be used to calculate the capitalization rate immediately after purchase; at all other times, the current market value of the investment should be used. This ensures that investors have a clear picture of the amount of capital tied up in an investment in relation to the profit being produced by that capital.

Capitalization rates are used by investors as a measurement of the length of time an investment property or security requires before recouping its costs. In the initial example, the $10,000 building would pay for itself in ten years, since ten percent of its cost is defrayed every year in net income. The potential for producing income is an important measure of the value of an investment and is often more useful to investors than the likely appreciation or value of the property itself.
Tim Ord
Ord Oracle

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