The Ulitmate Guide to Capitalization Factor

The capitalization rate, also known as the cap rate, is a financial term primarily used in the real estate investment industry. 

It is a quick tool to compare various real estate investments - such as homes, apartments, office buildings, commercial properties, and more.

The formula of the capitalization rate 

To calculate the capitalization rate, we must divide the net annual profit by the property's current market value:

the capitalization rate = net annual profit / current market value 

Net annual income means income and fewer expenses on the property.

Example: A property costs $ 1,000,000 and is expected to generate a net annual income of $ 100,000. 

In this case, the value equals 10%, meaning the property yields 10% yearly. Alternatively - the investor will take ten (1/0.1) years to recoup the investment in the property.

It should be noted that the current market value should be used and not the property's original purchase price.

How does the capitalization rate is used for Investment decision-making?

Suppose an investor is considering purchasing one of two real estate properties. The first property costs $ 1,000,000 and is expected to generate a net annual income of $ 100,000, as in the example above. The second asset costs $ 1.5 million and will yield $ 160,000 annually. As stated above, for the first property, the capitalization rate equals to 10%.

The capitalization rate for the second property equal to 10.67% (160,000 / 1,500,000). Since the capitalization rate of the second asst is high, the investor should invest in the second asset.

How does the change in the price of the property change the capitalization rate?

If the property price rises and the annual income remains unchanged - the capitalization rate decreases. For example, if the price of the second property increases from 1,500,000 to 1,600,000 and the income is the same - 160,000 - the capitalization rate will decrease to 10%.

Similarly, the capitalization rate will increase if the annual income increases and the property price does not change.