Although there are many variations, the cap rate is generally calculated as the ratio between the annual rental income produced by a real estate asset to its current market value.
In instances where the purchase or market value is unknown, investors can determine the capitalization rate using a different equation based upon historical risk premiums, 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 are subtracted from gross lease income) during one year, then: The property building's capitalization rate is 10% percent, or in other words, one-tenth of the building's cost is paid by the net proceeds earned in the year.
If the owner bought the building twenty years ago for $200,000 that is now worth $400,000, his cap rate is: The investor must take into account the opportunity cost of keeping their money tied up in this investment.
Taking into account risk and how much interest is available on investments in other assets, an investor arrives at a personal rate of return he expects from his money.
One advantage of capitalization rate valuation is that it is separate from a "market-comparables" approach to an appraisal (which compares 3 valuations: what other similar properties have sold for based on a comparison of physical, location and economic characteristics, actual replacement cost to re-build the structure in addition to the cost of the land and capitalization rates).
Although NOI is the generally accepted figure used for calculating cap rates (financing and depreciation are ignored), this is often referred to under various terms, including simply income.
Capitalization rates are a tool for investors to use for estimating the value of a property based on its net operating income (NOI).
Some factors considered in assessing risk include creditworthiness of a tenant, term of lease, quality and location of property, and general volatility of the market.
If the inverse is true, cap rates will be driven down by the increased demand stemming from lower opportunity cost of capital.
Rental rates are driven by a variety of supply and demand factors which make up a separate market for rentable space.
Property values based on capitalization rates are calculated on an "in-place" or "passing rent" basis, i.e. given the rental income generated from current tenancy agreements.
The ERV states the valuer's opinion as to the open market rent which could reasonably be expected to be achieved on the subject property at the time of valuation.
The cap rate only recognizes the cash flow a real estate investment produces and not the change in value of the property.
The actual realised rate of return will depend on the amount of borrowed funds, or leverage, used to purchase the asset.
A Wall Street Journal report using data from Real Capital Analytics and Federal Reserve[2] showed that from the beginning of 2001 to end of 2007, the cap rate for offices dropped from about 10% to 5.5%, and for apartments from about 8.5% to 6%.