The capitalization rate is a measure of rate of return that relates net income to the value of the property. If the cap rate is correct for the market environment, it will attract investors to the property. The overall capitalization rate consists of a return on the investment and a return of the investors money.
To calculate the capitalization rate, the investor divides the net income of the property by the value of the property, arriving at the capitalization rate. For instance, if you had a $1,000,000 property with a $100,000 net income, your capitalization rate would be 10%.
The capitalization rate, as a stand alone measure of investment, is useless unless it is compared to the market capitalization rates for similar properties. It is a mistake to view a cap rate on one property as a yardstick of value unless it is compared to other similar properties. As an example, if your property has a 10% capitalization rate and similar properties in the area are at 6-7%, you need to go back and re-evaluate your numbers and assumptions. A lower cap rate usually will indicate a lower risk property, but not always.
A word of caution on capitalization rates: when you look at similar properties, you must be very objective about the condition, size and location of the comparison properties. It is useless to compare a property that is a Class C property to a Class A property even though they might be in the same geographical area. In addition, carefully review the financial statements of the property to ensure that the net income calculation is complete and accurate. For instance, be sure to exclude the principle reduction portion of the loan payment when you are calculating net income.
The property size can influence cap rates. As an example, anything below four units of a multi-family property will not benefit from a capitalization rate calculation. Single family homes used as rentals should not be subject to capitalization rate screening as the numbers would be meaningless.
Capitalization rate calculations are one tool in commercial real estate analysis. The cap rate should be bundled with other calculations and cash flow analysis in order to determine if the subject property is a suitable addition to your investment portfolio.