Capitalization rate

Capitalization rate (or “Cap Rate”) is a real estate valuation measure used to compare different real estate investments. Although there are many variations, a cap rate is often calculated as the ratio between the net operating income produced by an asset and the original capital cost (the price paid to buy the asset) or alternatively its current market value.

The rate is calculated in a simple fashion as follows:

For example, if a building is purchased for $1,000,000 sale price and it produces $100,000 in positive net operating income (the amount left over after fixed costs and variable costs is subtracted from gross lease income) during one year, then:

The asset's capitalization rate is ten percent; one-tenth of the building's cost is paid by the year's net proceeds.

If the owner bought the building twenty years ago for $200,000, his cap rate is

However, the investor must take into account the opportunity cost of keeping his money tied up in this investment. By keeping this building, he is losing the opportunity of investing $1,000,000 (by selling the building at its market value and investing the proceeds). As shown above, if a building worth a million dollars brings in a net of one hundred thousand dollars a year, then the cap rate is ten percent. The current value of the investment, not the actual initial investment, should be used in the cap rate calculation. Thus, for the owner of the building who bought it twenty years ago for $200,000, the real cap rate is ten percent, not fifty percent, and he has a million dollars invested, not two hundred thousand.

As another example of why the current value should be used, consider the case of a building that is given away (as an inheritance or charitable gift). The new owner divides his annual net income by his initial cost, say,

Anybody who invests any amount of money at an undefined rate of return very quickly has an undefined percent return on his investment.

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