# What Is Cap Rate in Business

Income growth – or the expectation of it – is one of the most important data points to evaluate when analyzing capitalization rates, as it leads to significant changes in property values. For example, suppose the net operating income (NOI) of a property in the first year is \$100,000 with a capitalization rate of 8% and a value of \$1.25 million. If income increases by 5% to \$105,000 in the second year and the capitalization rate remains the same, the value of the property is now \$1.31 million. What is a capitalization rate? The capitalization rate, often referred to only as the capitalization rate, is the ratio of net operating income (NOI) to the value of the real estate asset. For example, if a property was recently sold for \$1,000,000 and had a NOI of \$100,000, the capitalization rate is \$100,000/\$1,000,000, or 10%. Essentially, the different income generated by the property, the expenses related to the property and the current market valuation of the property can significantly change the capitalization rate. Leases increase risk and, depending on the magnitude of that risk, can have a depressing effect on the cap rate applied to each individual tenant – meaning that cap rates increase and the value of that lease decreases, which has a pro-rated impact on the overall value of the building. The bottom line is that a building`s capitalization rate can`t give you a clear idea of whether a property will be a good investment. But knowing the capitalization rate and comparing it to similar properties on the market can lead to a more in-depth look at the circumstances of a particular property and help an investor narrow down the list of choices. For this reason, the average cap rate for a Class B office building in Manhattan can be 5% to 5.3%, while a Class B office building in Tampa can have a cap rate of 6.75% to 7.5%. The above presentation corresponds to the basic formula of the capitalization rate mentioned in the previous section. The value of the expected cash flows represents net operating income and the asset is in line with the current market price of the property. Therefore, the capitalization rate is equal to the difference between the required return and the expected growth rate.

That is, the capitalization rate is simply the required return minus the growth rate. The solution is to create a multi-period cash flow projection that takes into account these changes in cash flow and, ultimately, perform a discounted cash flow analysis to get a more accurate valuation. If you need help creating a cash flow forecast and performing discounted cash flow analysis, you should try our commercial real estate analysis software. The risk-free interest rate approach mentioned above is not the only way to think about capitalization rates. Another popular approach to calculating the capitalization rate is to use the investment range method. This approach takes into account the return for the lender and equity investors in a transaction. The range of the investment formula is simply a weighted average of the return on debt and the required return on equity. Suppose we can guarantee a loan at value (LTV) of 80%, which is amortized at 6% over 20 years. This results in a mortgage constant of 0.0859, and let`s also assume that the return on equity requirements is 15%. This would result in a weighted average capitalization rate of 9.87% (80%*8.59% + 20%*15%).