The capitalisation rate (cap rate for short), is the percentage return on a property investment (before the cost of debt funding and taxes).
Similar to a price earnings ratio for the valuation of equities (businesses), it is an earnings-driven valuation approach for the valuation of commercial real estate (CRE) assets.
Formula: annual net income / property purchase price x 100.
Annual net income equals one forward-projected year of earnings, with the first month (of twelve) starting from the anticipated transfer of ownership date.
Example: a property, from presentation of the sales packs, will take an anticipated 4 months to transfer. Therefore the annual net income for purposes of calculating the property value will be the net income of months 5 to 16.
The synonym for cap rate is yield.
- A property is pushing out R10M per year in net income
- The property’s sales price is R100M
- The capitalisation rate or yield on that property is 10% (R10M ANI / R100M purch price)
- That same property pushing out R10M per year’s price is negotiated down to R80M
- The capitalisation rate or yield on that property is 12.5% (R10M ANI / R80M purch price)
In summary: the lower a cap rate or yield, the more expensive the property.
Where it can get confusing
So, for a property pushing out R10M in annual income, if a seller can sell it at a:
- (low) 5% capitalisation rate or yield –> the seller will achieve R200M (calc: R10M / 5%)
- (high) 15% capitalisation rate or yield –> the seller will achieve R66.7M (calc: R10M / 15%)