Capitalization Rate

A capitalization rate is the ratio of a property's annual net operating income to its price or appraised value. Net operating income is the rent the property is expected to collect after vacancy and credit losses, less the operating expenses of running it, and before any financing cost. Divide that figure by the price and the result is a percentage: the return the building itself produces to an unleveraged owner in a year, before tax.

"Cap rate" is the market shortening of capitalization rate, and the two mean the same thing. The longer name is worth knowing because it points at where the measure comes from. It is one component of the income approach to value, the appraisal method that estimates what a property is worth from the income it produces. IRS Publication 561, listing the approaches an appraiser may use for real estate, calls the second one "Capitalization of Income" and describes it as capitalizing the net income from the property "at a rate that represents a fair return on the particular investment at the particular time, considering the risks involved," adding that "the key elements are the determination of the income to be capitalized and the rate of capitalization."

The exclusions are the whole point of the measure, and they are what people forget. Net operating income is computed before the mortgage. California's Property Tax Rule 8, which sets out the income approach for assessment purposes, states the principle about as clearly as a regulation can: gross outgo "does not include amortization, depreciation, or depletion charges, debt retirement, interest on funds invested in the property, or rents and royalties payable by the assessee for use of the property." Read that list once and the measure's design becomes obvious. It is trying to describe the property, not the person who happens to own it, so everything specific to the owner's financing and tax position is stripped out.

Two cautions travel with that regulation. It is a state property-tax rule rather than a definition of the market convention, and its exclusion list is broader than the market's: Rule 8 also removes property taxes and certain corporate income taxes from gross outgo, because subsection (f) instead loads a property-tax component into the rate itself for assessment purposes. A market net operating income treats property taxes as an ordinary operating expense. The shared principle is what matters here: financing and depreciation are outside the income being capitalized.

Which means the cap rate cannot tell you what a buyer will earn. Two buyers can purchase the same building on the same day at the same price and the same cap rate and have completely different outcomes, because one paid cash and the other borrowed at a rate that may be above or below the property's own yield. When the borrowing cost is below the cap rate, debt raises the return on the cash invested; when it is above, it lowers it, and the effect grows with the size of the loan. None of that is visible in the cap rate, and none of it is a defect in the cap rate. It is a different question, answered by cash-on-cash return.

A market cap rate is derived from sales, which makes it a comparison rather than an independent judgment. Rule 8 describes one of two ways to develop a rate, and says it is preferred where the sales prices and incomes are available: "by comparing the net incomes that could reasonably have been anticipated from recently sold comparable properties with their sales prices," which it calls the market-derived rate. So applying a market cap rate to a property's income tells you what the market has recently paid for similar income, not what the income is objectively worth. That is genuinely useful and it is also circular in a rising or falling market, which is why the same building can be worth materially different amounts in two years with identical rent rolls.

Price and cap rate move inversely, and the intuition runs the wrong way. A falling cap rate on unchanged income means buyers are paying more for the same income, which is a strengthening market and a worse entry price. A rising cap rate means the opposite. An owner reading "cap rates rose this year" as good news about their existing holding has it backwards; it is good news for the next buyer.

Three neighboring measures answer different questions and are frequently swapped. Cash-on-cash return divides the cash flow left after debt service by the cash actually invested, so it does exactly what the cap rate refuses to do. The gross rent multiplier divides price by gross rent and ignores expenses entirely, which makes it a quick screen rather than a valuation; Rule 8 recognizes gross income and gross rent multipliers as a separate technique for the same reason. The 1 percent rule, that monthly rent should be about 1 percent of price, is a rule of thumb with no expense data in it at all. Finally, net operating income is not the taxable result of owning the property: depreciation and mortgage interest are deductible in computing rental income for tax and are excluded from net operating income, so the two figures will not match and are not meant to.

Build the income figure first, then divide. Start with the gross scheduled rent, subtract expected vacancy and credit loss to get effective gross income, subtract the operating expenses of running the building, and the remainder is net operating income. Divide that by the price or the value being tested.

A hypothetical example. A small apartment building is offered at $1,250,000. Its gross scheduled rent is $132,000 a year. Allow 5 percent for vacancy and credit loss, which is $6,600, leaving effective gross income of $125,400. Operating expenses, meaning property taxes, insurance, management, maintenance, utilities the owner pays and reserves, total $47,400. Net operating income is therefore $78,000 ($125,400 minus $47,400), and the capitalization rate is 6.24 percent ($78,000 divided by $1,250,000).

The same building, two buyers. Buyer A pays cash. Her annual return on the $1,250,000 she committed is the cap rate itself, 6.24 percent. Buyer B borrows $875,000 of the price on interest-only terms at 7 percent, which costs $61,250 a year, and invests $375,000 of his own money. His cash flow is $16,750 ($78,000 minus $61,250), which is 4.47 percent on the $375,000 he put in. Same property, same price, same cap rate, and a return on invested cash nearly 30 percent lower, because he borrowed above the property's own yield. Had he borrowed at 5 percent instead, the interest would be $43,750 and the cash flow $34,250, or 9.13 percent on the same $375,000.

And the price relationship. If the building's net operating income stays at $78,000 and competing buyers push the price to $1,400,000, the cap rate falls to 5.57 percent. Nothing about the building changed. Only what people will pay for its income did.

Pros

• It reduces a property to one comparable number, which is what makes buildings of different sizes and prices comparable at all.
• Stripping out financing means the measure describes the asset rather than the buyer, so two people can discuss the same property without discussing their balance sheets.
• Inverting it gives an income multiple, which connects property pricing to the way other income-producing assets are quoted.
• Because market rates are derived from actual sales, a cap rate carries real information about what buyers are currently paying.

Cons

• It says nothing about the return a particular buyer will earn, because debt service is outside the numerator by design.
• It depends entirely on the quality of the net operating income figure, and a seller's expense estimate is the easiest number in a listing to understate.
• Reserves for roofs, systems and turnover are frequently omitted from the expense line, which raises the stated cap rate without changing the building.
• It is a single-year snapshot and carries no information about rent growth, lease rollover or capital spending ahead.
• Being derived from recent sales makes it circular in a moving market, so it confirms prevailing prices rather than testing them.