Capitalization Rate: Uses and Limitations

June 16, 20225 min read
Capitalization Rate: Uses and Limitations
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Three Takeaways:

  • Capitalization rate, or cap rate, can be used to estimate annual rates of return from a commercial real estate investment.
  • Cap rates are more useful as a comparison tool – measuring the relative risk value of similar investments – than as an absolute metric. 
  • The model comes with its set of limitations, especially as it relates to short-term and leveraged investments.

While there’s no crystal ball solution to predicting return on investments, there are tried and true metrics that can help make informed decisions. In the world of commercial real estate for example, a widely used metric is the capitalization rate — or cap rate for short – which investors use to estimate a property’s annual profitability. Cap rate is even more effective as a comparison tool, especially in the context of assessing relative risk. As with any model however, it doesn’t capture every pertinent factor of dynamic, real life situations, which is a caveat investors have to consider.

Real estate as an investment

In general, the real estate market is less volatile than stocks and bonds, so it has historically attracted investors looking for a steady source of income outside of traditional markets. Property based investments also typically trade at a yield premium to the U.S. Treasuries, making them a great alternative when Treasury rates are low.

Aside from investing directly, which can either be for the short (i.e., flipping) or long term (i.e., becoming a landlord), commercial real estate investors can also allocate funds to trusts, which then manage properties in their stead. For example a real estate investment trust (REIT) is created when a corporation (or a trust) is formed to use investors’ money to purchase, operate, and sell income-producing properties. REITs are then bought and sold on major exchanges, just like stocks and exchange-traded funds (ETFs). 

Whether it’s REIT managers or individuals, real estate investors can use cap rate to estimate percent return and assess risk for long-term investments. The handy tool not only quantifies their expected return, but also indicates the time it’ll take to recover the principal amount. For example, property with a 10% cap rate can be interpreted as having an annual 10% return rate, which means it’ll take about 10 years to recover the principal amount. 

While cap rates can be used as an absolute metric, where they estimate percent return for one property in particular, they’re even more useful as a comparison tool that helps assess the relative risk of similar real estate investments.

Calculating cap rate

There are several ways to calculate cap rate. The most basic formula is NOI, or the net operating income, divided by the market value of the property. 

Capitalization Rate = Net Operating Income / Current Market Value

The NOI itself is also derived from two different values: the expected income minus any expenses that go into maintaining the unit. For example, if the landlord of a rental unit expects $40,000 from the annual rent of a property, but due to upkeep and repairs, also spends $5,000, the NOI would be $35,000. 

Another formula to figure out cap rate is using the original capital cost of the property.

Capitalization Rate = Net Operating Income / Purchase Price

The above formula isn’t as popular for two reasons. First, it gives unrealistic results for old properties that were purchased in the past for low prices. Second, it can’t be applied to inherited property because their purchase price is at zero, making the division impossible.

Since property prices fluctuate frequently, the first formula is a more accurate representation of the dynamic value that a property can take on.

Uses & assumptions

In addition to estimating annual return on property, cap rates are useful when assessing risk. A classic example to demonstrate this concept centers on two apartments, identical in all aspects except their geographic location. The first one is located in the city center and the other one is on the outskirts. 

According to the formula, the cap rate will be higher for properties that generate higher net operating income (NOI/market value) but have a low market value. 

Assume the property in the center is in more demand, which would mean both the market value and the rental price for it is high. But the expected income from rent will also be offset by higher maintenance fees, which lowers NOI. In that case, all other things being equal, the cap rate for the apartment in the city is lower. 

The same apartment is also the safer investment choice because it can be rented and sold at a higher price. Generally, a lower cap rate corresponds to less risk for the investor. 

Conversely, if the valuation is low, the opposite is true. The return, or the cap rate, can be high but it’s at the expense of a low market value. The investor is incurring more risk by buying the apartment that’s further from the city center because she might not be able to rent or resell the property at a worthwhile price. 

As the example above demonstrates, there are many factors to consider even when the calculation is stripped to its most basic form. Varying levels of income, expenses related to the property, and the current market valuation of the property can all significantly change the capitalization rate.

There are also situations when the cap rate isn’t useful. Properties that are bought to be flipped or rented out on a short-term basis don’t have accurate cap rates, because the 12-month frame of reference becomes less relevant. Due to high tenant turnover in these situations, there’s also an expectation for there to be fluctuations in income occupancy, and operating expenses. These factors all affect NOI, which in turn results in an unreliable cap rate calculation.

Also, cap rate assumes that the property is bought for cash and not on loan. The upside to this is that it isolates the return from debt, so investors can see, without leverage, what their “ideal” return should be. The downside is that it doesn’t take into account any costs associated with a mortgage, which is how many landlords acquire property. Similarly, cap rate also discounts other costs of acquiring the property, such as closing costs and brokers’ fees.

Yieldstreet and Real Estate Investment Opportunities

Real estate can be  a key component of a well diversified portfolio.  Yieldstreet’s platform has opened up the opportunity to invest in real estate – among other private market assets – by allowing investors to build a diversified portfolio within the space. Potential investment opportunities include – among others – single family rentals (SFR), multi-family rentals, industrial property and REITs.