I wish I knew what capitalisation rate was, but I’m too embarrassed to ask
The capitalisation rate (or cap rate) is used to value real-estate investments. It is calculated as annual net operating income (NOI) produced by a property, divided by the current value of the property. In turn, net operating income is the income that a property generates – which will usually mostly be rent, but may include other recurring income – minus the operating expenses. It does not deduct the costs of financing the investment, such as interest payments on a mortgage.
Let’s assume that a property produces NOI of £5,000 per year and is valued at £100,000. Then the cap rate is 5% (£5,000 ÷ £100,000). Conversely, let’s assume that the average cap rate for recent transactions on a series of comparable properties is 7.5% and we have a property with NOI of £3,000. Then we might value this property at £40,000 (£3,000 ÷ 7.5%).
Cap rates give investors an idea of what returns a property might generate in terms of income, excluding the potential for capital gains and losses. This can be compared to the cost of financing the investment – interest costs for debt, the opportunity cost (ie, the return that could have been got on other investments) for equity or probably a combination of the two – to assess how attractive it is. It is crucial to make sure that
NOI reflects the likely longterm net income from the property. If investors find that maintenance costs and other capital expenditure are greater than anticipated, or rental income is lower due to higher vacancy periods, their returns will be lower than the cap rate they assumed.
Cap rates depend on the type of building, the location and the prospects for rental growth (properties expected to see faster growth will be on lower initial cap rates). They also change over time depending on interest rates. If rates go up, investors require a higher return from real estate to make it an attractive investment. Hence cap rates must rise, which in turn generally means that property values must fall.