Understanding Capitalization Rate

Some common approaches to valuing a business as a going concern involve determining a good measure of earning power and capitalizing it. This determines the value of the business to an investor based on the future returns he or she can reasonably expect. A Capitalization Rate, commonly referred to as a Cap Rate, serves as the basic metric to value a Real Estate deal. It is the yearly rate of return expected on an all cash investment in a real estate property.

For example, a Cap Rate of 10% on an investment of $5 Million means that you shall receiveĀ  $500,000 each year as a return on your investment.

The formula for Cap Rate= Net Operating Income / Value of Property

Capitalization Rates are also commonly used to estimate the value of an income-producing property. Choosing a capitalization rate is very important. Using an incorrect rate could drastically misrepresent the value because of the leveraging effect these rates have on value. Determining which rate is appropriate takes experience and an understanding of the market in which a business operates.