The capitalization rate or cap rate is the current yield on a real estate investment property.
Unlike the discount rate (i.e. the required rate of return), the cap rate is applied to the expected year-1 Net Operating Income (NOI) of the investment property; the discount rate is applied to future income on top of the year 1 income. The formula for the cap rate can be shown below:
Capitalization Rate = Net Operating Income / Property Value
where NOI = Total rental income – rental loss on vacancies – operating expenses
An example could be taken from one of Suntec REIT’s (SGX:T82U) real estate investment properties as shown below:
|Net operating income
Given the calculation, we derive a cap rate of 4.5%. However, this number has to be compared with its peers or a historical average. A trend which shows compressing cap rates might mean values are being bid up. Calculating an investment property’s cap rate can also be useful if we want to find out whether the property has been aggressively valued. This can be seen if properties of similar characteristics such as its type (i.e. commercial, retail and/or office), age, location, gross foot area (GFA) and rental income have different cap rates. In addition, we can also calculate a property’s value based on a given cap rate based on an industry benchmark or peers’ average. While cap rates can be useful for a quick back of the envelope calculations, it assumes that the net operating income is stable and projects into perpetuity, similar to the Gordon Growth Model (GGM).
Cap Rate Driving Factors
Cap rate is driven by a few factors such as the property’s age, the types (i.e. office, retail or residential tenants), creditworthiness of the tenants, location and supply & demand market fundamentals.
Value in Action
The capitalization rate or cap rate is the return on a property asset. It is useful for calculating a property’s value given the rental income. Some of the driving factors which determine the cap rate include the types of tenants, supply & demand fundamentals and a property’s age.
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All views and opinions articulated in the article were expressed in Willie’s personal capacity and do not in any way represent those of his employer and other related entities. Willie do not own any shares in the companies mentioned above.