Capitalisation Rate

The capitalization rate is a financial measure used to assess the profitability of a real estate investment. It is computed by dividing the property's net operating income by its current market value.
Capitalisation Rate
3 min
28-June-2024

The capitalisation rate, more popularly known as the cap rate, is a popular ratio determined while investing in real estate. It calculates the expected returns from an investment property. This rate is determined by dividing the property’s annual net operating income (NOI) by its current market worth or purchase price.

The cap rate gives investors a quick way to compare the profitability of different real estate investments. It tells what percentage of the property’s value you can expect to earn in income each year.

Let’s understand the capitalisation rate meaning in detail, learn its calculation, and check its various pros and cons.

What is the capitalisation rate?

The capitalisation rate measures how much money you can expect to make from a property investment each year in comparison to the cost of buying that property. Commonly, investors use the cap rate to compare the profitability of different properties. As per a thumb rule, if two properties are similar in location and other factors, the one with the higher cap rate is considered a better investment because it offers higher returns.

Moreover, changes in cap rates indicate trends in the real estate market. For example:

  • Say capitalisation rates are going down.
  • Now, this means mean property values are going up.
  • Most investors interpret this situation as a "hot" market offering opportunities to earn capital appreciation.

Also, the cap rate gives an idea of the risk associated with an investment. Usually, a lower cap rate signals reduced risk but also lower returns. On the other hand, a higher cap rate indicates greater returns but also comes with increased risk.

Formula to calculate capitalisation rate

You can calculate the capitalisation rate for a property using the following formula:

Capitalisation rate = Net Operating Income (NOI) / Current Market Value


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Example of cap rate

Say you are considering buying a commercial property in Delhi for Rs. 50,00,000. This property generates an annual rental income of Rs. 5,00,000. After subtracting operating expenses (like maintenance and property taxes) of Rs. 1,00,000, the net operating income (NOI) is Rs. 4,00,000.

Now, to calculate the cap rate, you would use the above formula:

Capitalisation rate = (Rs. 4,00,000 / Rs. 50,00,000) x 100 = 8%

This 8% cap rate indicates that for every Rs. 100 you invest in this property, you can expect an annual return of Rs. 8. If another similar property in Delhi has a cap rate of 6%, the first property (with an 8% cap rate) is considered better investment due to its higher return.

How to calculate the capitalisation rate ?

You can calculate the capitalisation rate (cap rate) for a property by following these three simple steps:

Step I: Determine the Net Operating Income (NOI)

  • Calculate the annual income the property generated after subtracting operating expenses, like:
    • Maintenance
    • Property taxes
    • Insurance
  • You can refer to the following formula:
    Net Operation Income (NOI)= Annual Income - Operating Expenses

Step II: Find the property value

  • Use the current market value of the property.
  • Alternatively, you can also consider the purchase price of the property.

Step III: Apply the capitalisation rate formula:

  • Capitalisation rate = Net Operating Income (NOI) / Current Market Value

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Interpretation of cap rate

The capitalisation rate (cap rate) helps investors understand the likely returns on a real estate investment. Generally, a higher cap rate indicates higher returns but often comes with a greater risk. This situation is common in emerging or less stable markets.

On the other hand, a lower cap rate indicates lower expected returns from a property along with lower risk. This is common in stable and well-established real estate markets.

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What affects the capitalisation rate?

It is essential to note that several factors influence the capitalisation rate (cap rate) of a property and determine its attractiveness and risk level. Let’s study some major ones:

Location

  • Prime locations usually have lower cap rates
  • That is mainly because of:
    • Higher property values
      and
    • Lower risk
  • Conversely, less desirable locations have higher cap rates.

Property condition

  • Well-maintained properties often attract lower cap rates.
  • That’s because they require less immediate investment and pose less risk.

Market conditions

  • In a booming market with high demand, cap rates decrease due to an increase in the value of the properties.
  • On the other hand, in a sluggish market, the capitalisation rates usually increase.

Interest rates

  • An increase in interest rates leads to higher cap rates.
  • This happens because of higher borrowing costs, which make investments less attractive.

Tenant quality

  • Properties with long-term, reliable tenants (like established businesses) often have lower cap rates due to stable income streams.

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Advantages of the capitalisation rate

The capitalisation rate is a valuable tool for real estate investors. It provides essential insights into:

  • Profitability
  • Risk
  • Market conditions

Let’s check out some major advantages of cap rate and see how it supports better investment decisions.

Quick comparison

  • The cap rate provides a simple and quick way to compare the profitability of different real estate investments.
  • Using it, investors can even benchmark properties:
    • Against each other
      and
    • Against market averages

Risk Assessment

  • Cap rates can help gauge the risk level of an investment.
  • Higher cap rates often indicate higher risk and vice versa.
  • Also, it helps in understanding how risky are the different market segments and property types.

Tool for making investment decisions

  • Cap rates allow investors to identify properties with high-income potential relative to their cost.
  • This identification helps in deciding where to allocate investment funds for maximum returns.

Indicator of market trends

  • Changes in cap rates indicate broader market trends, such as whether it’s a buyer’s market or a seller’s market.
  • Lower cap rates usually suggest rising property values, while higher cap rates could indicate a downturn.

What is a good capitalisation rate?

Generally, a good capitalisation rate falls between 5% and 10%. This range indicates a balanced return on investment. Also, it considers the varying degrees of risk and market conditions across different regions and property types.

For example:

  • Prime locations with higher demand might deliver cap rates closer to the lower end of this range, which is around 5-6%.
  • On the other hand, properties in emerging or less desirable areas may offer higher cap rates (up to 10%) to compensate for increased risk.

Disadvantages of the capitalisation rate

Despite being a trend indicator and a popular investment decision tool, the capitalisation rate has several disadvantages as well. Let’s look at them:

Sensitivity to property valuation

  • Cap rates are heavily dependent on the property's valuation.
  • This causes significant fluctuations in the cap rate even when there are small changes in property value.
  • This high sensitivity can sometimes lead to skewed investment decisions.

Does not account for financing

  • Cap rates are based on the property's net operating income (NOI), which is divided by its current market value.
  • However, they do not consider the impact of financing terms, such as:
    • Interest rates
    • Loan terms
    • Any special conditions
  • Usually, these terms vary widely and substantially affect actual returns.

Ignores differences in risk

  • Cap rates treat all investments equally based on their NOI and market value.
  • It ignores the variations in:
    • Risk profiles
    • Location
    • Tenant quality, and
    • Market conditions
  • There is a high probability that properties with the same cap rate may have significantly different risk levels.

Conclusion

The capitalisation rate or cap rate is a straightforward tool for comparing real estate investments based on their likely returns. It helps investors to make quick assessments of profitability and market trends. However, it is sensitive to property valuations and ignores the varying levels of risk between properties.

Hence, investors should use it cautiously and supplement it with a comprehensive analysis. Also, it must be noted that real estate investments are different from mutual funds. While the former offers higher returns but requires active management, the latter provides the benefits of diversification with professional management.

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Frequently asked questions

What is the overall capitalisation rate?
Capitalisation rate is the ratio of a property's net operating income (NOI) to its current market value or purchase price. Cap rate shows the overall return expected by real estate investors from a property.
What is the going in capitalisation rate?
This is the initial rate of return on a real estate investment. It is calculated by dividing the property's first-year net operating income (NOI) by its purchase price. Going-in cap rate helps investors assess the profitability at the time of purchase.
What is an example of a capitalisation rate?
Say a property generates Rs. 1,00,000 in net operating income annually and is valued at Rs. 25,00,000. In this case, the capitalisation rate would be 4% (Rs. 1,00,000 / Rs. 25,00,000).
What is the formula for capitalised rate?
A capitalisation rate is calculated as net operating income (NOI) divided by property value or purchase price. This rate shows how much returns you can generate from real estate investments.
What is the difference between the cap rate and the capitalisation rate?
Cap rate is a shorthand for capitalisation rate, and the two terms are used interchangeably in real estate. There is no difference between them as both measure the rate of return on an investment property.
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Bajaj Finance Limited (“BFL”) is an NBFC offering loans, deposits and third-party wealth management products.

The information contained in this article is for general informational purposes only and does not constitute any financial advice. The content herein has been prepared by BFL on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, BFL cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. 

This information should not be relied upon as the sole basis for any investment decisions. Hence, User is advised to independently exercise diligence by verifying complete information, including by consulting independent financial experts, if any, and the investor shall be the sole owner of the decision taken, if any, about suitability of the same.