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Capitalization Rate Definition
A capitalization rate, or cap rate, is used by real estate investors to evaluate an investment property and show its potential rate of return, helping the investor decide if she should purchase the property.
The formula is:
Net Income / Total cost of acquisition
Net Income = Revenue – Operating expenses
This indicator is commonly used in the evaluation of real estate, but it can be used for other assets in the same way. The capitalization rate of an investment may be slightly different from one investor to another, and determining its exact value requires a deep understanding about how you will pay for certain operating costs such as repairs or administration.
A Little More on Capitalization Rate
To calculate the capitalization rate of a property, you must know the net income that the property will generate in a year. The net operating income of a property is the money that you will have after subtracting fixed and variable operational costs from the gross income obtained by rent or percentage sales. Fixed costs generally include mortgage interest, insurance, property taxes, or property management fees. Variable costs may include items such as expected repairs or vacancy rates.
Next, you need to know what you pay to acquire the investment property. Remember, if you need to take a loan to acquire property (like many people), the interest on your mortgage should be taken into account within the cost of maintaining the property, even if the capitalization rate is not affected.
Because many operational costs may vary from one investor to another, the capitalization rates for the same property may also vary. For example, a real estate investor who understands the construction of houses and makes repairs on their own can assume lower repair costs than an investor who hires these jobs with someone else. Similarly, if you are planning to perform property administration on your own, your cost for this service will be US $ 0, while someone looking to outsource this function will have to pay a percentage of the monthly rental income, reducing the rate of capitalization of property.
Example of Calculating the Capitalization Rate
Suppose an investment property is for sale for US $ 100,000. The tenants of the property have a contract for one year, which requires payment of US $ 1,000 per month, so the gross income for this property is US $ 12,000 per year. Suppose the annual property taxes are US $ 1,000; the property will need $2,000 in improvements over the next year; insurance costs US $ 800 per year; and a property manager agreed to manage this property for an annual price of US $ 2,000. The total operational costs would be US $ 1,000 + US $ 2,000 + US $ 800 + US $ 2,000 = US $5,800. The net operating income would be US $ 12,000 – US $ 5,800 = US $ 6,200. The capitalization rate would be US $6,200 / US $ 100,000 = 6.2%.
References for Capitalization Rate
Academic Research for Capitalization Rate
The rate of interest as cost factor and as capitalization factor, Machlup, F. (1935). The American Economic Review, 459-465. The impacts of changes in the interest rates on production and prices are mostly considered to be a result of productions’ changed costs. This paper evaluates the relative importance of interest as a cost component. Interest in fixed capital on previous investments has no effect on prices and on working capital, the effect of interest is entirely negligible on the prices than the cost of labour/material. A decline in the interest rate hardly increases investment in working capital. The effect of interest rate on investment goods’ prices is highly important by capitalizing future yields. However, if no future gains are expected, the interest rates mitigation, even as a capitalization factor, has no impact on production and prices.
Struggling to understand the stock market, Hall, R. E. (2001). American Economic Review, 91(2), 1-11. The stock market behaviour has perplexed economists. This paper shows that the stock market value contains low frequency and large swings increasing from 1950-1965, then to 1982 decreasing and then again increasing until today. These movements are because of the cash rational appraisal, the shareholders are going to receive in the future. The irrational markets provide profit opportunities for active investors while passive traders earn higher consistently. The author explains 3 main contributors to these movements, (1) changes in the debt claim value (2) changes in the equipment and plant value owned by the corporations and (3) changes in the intangibles’ value.
Financial dynamical systems., Carfi, D., & Caristi, G. (2008). Differential Geometry–Dynamical Systems. The objective of this paper is to define dynamical systems with the help of a state space demonstrating the financial development of standard economics. It explains many new results based on a certain type of actions. The findings are that this method of financial evolutions problems minimizes the heuristic techniques of financial maths to a well-founded mathematical theory, called the TDS (Theory of Dynamical Systems). It creates a deeper consideration of economic-evolution nature. In this research, the authors use common definitions of dynamical systems, i.e. Reversible & Non-Reversible algebraic structures.
Customer satisfaction, earnings and firm value, O’Sullivan, D., & McCallig, J. (2012). European journal of marketing, 46(6), 827-843. This paper investigates the relationship between firm value, customer satisfaction and earnings. The authors use the Ohlson Model to see the effect of customers satisfaction on Tobin’s Q, which is a measure of performance of a firm in a capital market framework extensively used in research. The authors draw data from COMPUSTAT on the performance of the firm and integrate it with data from the ACSI (American Customer Satisfaction Index) on customer satisfaction. The findings are that there is a positive effect of customer satisfaction on the firm value. Critically, this effect is over and customer satisfaction positively moderates the relationship of firm value and earnings.
Private placement of common equity and earnings expectations, Goh, J., Gombola, M. J., Lee, H. W., & Liu, F. Y. (1999). Financial Review, 34(3), 19-32. This paper examines the earnings forecast revised by the analysts after the announcement of private capital placements. The findings are that the analysts revise their forecasts significant for earnings of the present year. In addition, there is a significant relationship between forecast revisions and abnormal returns of the announcement period, but no relation with risk changes following the equity placement m. These results have consistency with the Information Hypothesis which states that private capital placements convoy positive information related to future earnings.
Earnings components, accounting bias and equity valuation, Pope, P. F., & Wang, P. (2005). Review of Accounting Studies, 10(4), 387-407. This study addresses 3 problems in ABEV (Accounting-Based Equity Valuation), i.e. 1. How are valuation parameters concerned with accounting conservatism and earnings persistence, in case, the earnings elements add up or aggregate in valuation? 2. What are the implications of earnings elements aggregation in valuation for dynamics of abnormal earnings? 3. When is an earnings element irrelevant?
The authors demonstrate that in the case of aggregation of earnings components, the dynamics of abnormal earnings and valuation expressions are the Ohlson model generalizations with easy adjustments for the conservatism of accounting. Finally, an earnings component may be irrelevant in valuation whether it is predictable.
Earnings, adaptation and equity value, Burgstahler, D. C., & Dichev, I. D. (1997). Accounting review, 187-215. This article develops and evaluates the Option-Style Valuation Method, which predicts equity value as a function of book value and earnings where the function is subject to the relative book value and earnings value. Earnings measure the resources of a firm, used currently while book value measures the value of resources, a firm has, it does not depend on how to use the resources currently. If the ratio of both is high, the firm tends to keep the current method of using its resources. Earnings are a significant equity value determinant. When their ratio is low, the firm tends to adapt the resources to some other superior alternative use. Here, book value becomes a significant equity value determinant.
A coopetitive approach to financial markets stabilization and risk management, Carfì, D., & Musolino, F. (2012, July). In International Conference on Information Processing and Management of Uncertainty in Knowledge-Based Systems(pp. 578-592). Springer, Berlin, Heidelberg. This paper proposes a method for the stabilization of the financial markets using Game Theory and particularly, a new arithmetic model of Coopetitive Game and the CSDG (Complete Study of a Differentiable Game). The authors emphasize on 2 economic operators. One is a financial institute and the other is a real economic subject. They evaluate the interaction in the economic subjects of the 1st player ‘the Enterprise’ and the 2nd player ‘the Financial Institute’. The 1st player artificially leads to inconsistency between future and spot markets while the 2nd player cannot make arbitrages alone. Finally, the authors present 2 types of agreements. A fair agreement of transferable utility on the initial interaction and the similar kind in a coopetitive context.
Piercing the Corporate Veil-The Undercapitalization Factor, Gelb, H. (1982). Chi.-Kent L. Rev., 59, 1. A corporate commonly regards limited liability as an attribute that is indeed a benefit of running a business in the form of a corporate. This may diminish its importance to shareholders and from them, the creditors get a personal guarantee. Certain liabilities are covered by insurance, however, insurance or guarantees are not always available or sufficient to cover judgments. The frustrated plaintiffs may file a case against the shareholder defendants defying the principle of limited liability. The author recognizes a corporate as a separate entity from its shareholders and is, theoretically, based on the rule that the corporation’s liabilities, whether contract or tort, are its own liabilities, not if the shareholders.
The valuation of R&D firms with R&D limited partnerships, Shevlin, T. (1991). Accounting Review, 1-21. This study investigates whether investors of capital market in estimating values of R&D (Research & Development) firm’s equity, observe LPs (Limited Partnerships) of R&D as raising the liabilities and assets of the R&D firms. The contract terms suggest using the LO as a call option and option pricing theory to evaluate the asset and liability elements of the option. The authors derive the LO variable estimates from data provided by R&D firms. They include the LP variables estimates as explanatory variables in a regression model of cross-sectional market value on the basis of balance sheet identity. The results are in favour of the FASB and SEC positions. The author suggests the FSB play its role in required disclosures.
Capital income taxation in a two-commodity life cycle model: The role of factor intensity and asset capitalization effects, Davies, J., Whalley, J., & Hamilton, B. (1989). Journal of Public Economics, 39(1), 109-126. This article brings into consideration the effect of changes in capital revenue taxation in a 2 Commodity CLGM (Lifecycle General-Equilibrium Growth Model). In opposite to the 1 commodity framework of Solow Swan, the authors use a 2 commodify UTM (Unwa Type Model). They identify capital goods and consumption separately with a relative price determined endogenously. Consequently, they capture asset capitalization impacts and factor intensity impacts across sectors. The authors give their suggestions at the end and discuss what is the role of both of these effects in capital income taxation.