A cap rate, also known as capitalization rate, is a measure used to evaluate the viability of various investment vehicles such as real estate. It is calculated as follows:

A property whose selling price is $800,000 and generates an annual return of $95,000 has a cap rate of 11.88%. This is calculated as $95,000/$800,000. This measure can help you determine whether your investment is worth holding to or selling altogether. Assume the value of your property surges to $2 million after three years; the cap rate will decline to 4.75% (95,000/2,000,000). This means you could sell your investment and use that money to invest in another asset.

Once a business reaches maturity stage and profit growth stabilizes, it is imperative for the entrepreneur to search for alternative investments. Aside from the usual 401K and IRA, it is also advisable to expand the portfolio to include investments in rental property. It may be easy to shrug off this suggestion, as the memory of the recent housing bubble is still fresh in our minds. However, you can avoid losing out by using cap rate to evaluate your real estate investments to ensure that you obtain the maximum value for your investment.

**When to Use or Not Use a Cap Rate**

A cap rate can also help you make investment decisions when deciding whether to purchase two similar properties located near each other. If one property has a 6% cap rate, while the other has 12%, you should instinctively deduct that one asset has a higher risk premium. Cap rates can also be used to gauge the direction of the market.

By looking at the trend in cap rates in a certain property segment such as single-family homes, if the rates are declining, it means that the market for this sector is gradually heating. Therefore, looking at the historical data on cap rates can instantly let you know where property valuations are headed.

While capitalization rates can be computed quickly to help you decide whether a particular property is a good buy, there are times when it is irrelevant. This applies to situations when the income from the property is irregular and complex. In this case, you should use a method of valuation known as full discounted cash flow analysis.

**Breakdown of Cap Rate**

A cap rate is composed of a risk-free rate of return and risk premium. A risk-free rate of return is the rate of return on an investment that has no risk of incurring any financial loss. Normally, the risk-free rate is derived from the U.S. Treasury bond’s interest rate, which is considered financially safe.

**Example of Risk Premium in a Cap Rate**

Assume that you have about $1,000,000 that you intend to invest, and that the 10-year U.S. Treasuries have an annual return of 3 percent per year. It would seem like a good idea to invest in the treasuries and spend your whole life waiting for the regular checks. However, if you were given an opportunity to buy a Class A office block that is fully occupied, what would you do? You can quickly evaluate this by computing the cap rate and then checking it against the returns given by the treasury bonds.

If the cap rate on buying the office block is 6%, the risk premium is 3%, which represents the risk you will incur above the risk-free treasury bonds. The risk premium considers the age and lease terms of the property, the tenants’ creditworthiness and diversity, as well as macroeconomic factors such as surge in employment, population growth and construction of similar office spaces. Such factors are subjective, and hence it is up to you to use your business experience and judgement before buying the property. It also depends on your degree of risk aversion; if you are a risk-taker, the property may seem a good decision to you. However, if you are risk averse, the 3 percent risk premium may not be an adequate compensation to you, and hence it is better to stick to the 3% yield offered by the treasuries.

**Gordon Model of Calculating Cap Rates**

If you decide to invest in an asset, and forecast the net operating income (NOI) to increase each year at a certain rate, you can use the Gordon Model to approximate the cap rate. This model is normally used in finance industry to estimate a stock’s value using its dividend growth. It is calculated as Value=CF/k-g, where CF stands for cash flow, k for discount rate and g for the steady growth rate. This formula can also be rewritten as Value=NOI/Cap rate. This breaks the cap rate down into two parts (k-g), hence we can view the cap rate as the difference between the discount rate and the growth rate.

Assuming a property with annual NOI of $200,000 and we estimate that this cash flow will increase by 2 percent each year, how do you arrive at the best cap rate? If you want your investment to give you an annual return of 12%, the right cap rate is 10%, giving your property a value of $2 million.

This method is recommended if you want to evaluate a property whose cash flows increase each year. However, it has its own limitations, such as; what if the discount rate is equal to the growth rate? This will give your property an infinite value, which isn’t true in real life situation. Furthermore, if the growth rate is more than the discount rate, the model gives you a negative value, which is inapplicable. Either way, make sure that you are aware of the various assumptions before you use the model to evaluate an investment decision. It is also advisable to try this course to learn more about various factors that affect risk premium in real estate markets.

**Band of Investment Model**

This model takes into consideration the required rate of return (for stock investors) and return on debt (for lenders) when determining the appropriate cap rate. It is recommended for investing in properties that are financed using funds from other sources (equity investors and loans). Assume you finance a property that generates annual NOI of $950,000 using 50% in external funds. The interest on loan is 7% amortized over 15 years, while the rate of return on equity is 10%

Interest rate / 12 months

__________________________

{[1 + (interest rate / 12 months)]^{ # of years x 12 months}}-1

0.07/12

___________= 0.03154 per month

{1+ (0.07/12)^{ #10 x12}}-1

Per year, the figure will come to 0.0378 (0.03154 x 12 months). The figure is added to the interest rate (0.07%+0.0378) to arrive at a total of 10.78%. When weighted at 50% for both loans and equity in the order {(0.5×0.1078) + (0.5×0.1)}, the cap rate is 10.39%. You can now use this cap rate to estimate the value of the property at $950,000/.1039, which gives you a valuation of $9,143,407. You can learn more about band model of investment valuation in this course.