A Cap Rate, or Capitalization Rate, is a term used in commercial real estate to describe any rate used to convert income to value or price. This rate is not a rate of return and is actually a ratio. Some weaknesses and strengths of this method are indicated below:
Weaknesses:
- Does not consider impact of financing
- Does not consider the time value of money
- Limited utility for making investment decisions
- Does not consider the impact of taxes (income)
- Does not account well for uneven cash flows
Strengths:
- Easy to understand
- Easily extracted from comparable sales and serves as a valuable appraisal tool
- Minimal work to use
Conclusion:
This rate is often used in the market for pricing and valuing real property for stabilized cash flowing properties given the ease of use. From an appraiser's perspective, some of the weaknesses can be minimized by various techniques of adjustments to the income stream. The two key issues for applicability in this approach are using rates that are specific to the property, and the application of the rate to the cash flows in the same fashion that it was derived from the market.
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