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Real Estate Investment Potential: Understanding the Capitalization Rate

Updated: Dec 20, 2023

Cap Rate=(Current Market Value or Acquisition Cost/Net Operating Income (NOI)​)×100%

Average cap rates range from 4% to 10%. A lower cap rate implies that the property is more valuable and less risky due to type, class, and market. While a higher cap rate offers investors a higher return, that property investment typically has a higher risk profile. If the cap rate is greater than the interest rate, you'll generally come out ahead. If the cap rate is lower than the interest rate, you'll be relying on appreciation for your return, making it a riskier speculative investment.

There seems to be a consensus amongst investors that a projected cash on cash return between 8 to 12 percent indicates a worthwhile investment.

The formula for cash on cash return is: rent recieved/asset cost = % return

Cap rate measures the potential profit from an investment without factoring in financing. Cash on cash return tells you how much profit you receive for each dollar invested.

What does it mean to capitalize borrowing costs? Under IAS 23 Borrowing Costs, a company capitalizes borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset – one that necessarily takes a substantial period of time to get ready for its intended use or sale. Borrowing costs are capitalized as part of the cost of the asset when (a) it is probable that they will result in future economic benefits or service potential to the entity, and (b) the costs can be measured reliably. Costs expected to provide long-lasting benefits (>1 year) are capitalized, whereas costs with short-lived benefits (<1 year) are expensed in the period incurred. Certain costs are not allowed to be capitalized and should not be considered part of the acquisition cost. These costs include maintenance plans and warranties, software licenses, training costs, operating supplies and consumables, and project personnel salaries. Under US GAAP, the amount capitalized is calculated by applying the rate of the specific borrowing to the average expenditure and is not reduced by the interest earned from the temporary investment of funds.

Capitalizing: The expenditure is recognized on the balance sheet as an asset, and then the asset is reduced by depreciation or amortization annually, which is an expense on the income statement. The purpose of capitalizing a cost is to match the timing of the benefits with the costs.

Is cap rate the same as ROI? The cap rate is the expected return based on the property value, the ROI is the return on your cash investment, not the market value.

Is cap rate the same as yield? The cap rate calculation utilizes the property's current market value, which changes over time. The yield calculation utilizes the property's total cost, which is a static, one time number.

Real Estate Investment Potential: Understanding the Capitalization Rate
Real Estate Investment Potential: Understanding the Capitalization Rate