Net Income / Capital Cost = Capitalization Rate

For instance, if a building is purchased for $1,000,000 sale price and it produces $100,000 in positive net cash flow (the amount left over after fixed costs and variable costs are subtracted from gross lease income) during one year, then:

$100,000 / $1,000,000 = 0.10 = 10%

That asset's capitalization rate is ten percent.

Capitalization rates are a measure of how fast an investment will pay for itself in net cash flows. In the example above, the purchased building will be fully capitalized (pay for itself in net income) after ten years.

In real estate investment, commercial buildings are often valued according to project capitalization rates used as investment criteria. This is done by algebraic manipulation of the formula above:

Capital Cost (asset price) = Net Income / Capitalization Rate

For instance, in valuing the projected sale price of an apartment building that produces an annual net cash flow of $10,000, if we set a projected capitalization rate at 7%, then the asset value (or price we would pay to own it) is $142,857.10.

Capitalization rate calculation of this type used to be the standard in evaluating real estate investments and are still included as the third element of any complete appraisal. Capitalization rates do not, however, take into account the capital appreciation of an asset over time (an increase in value over time due to a rise in market price), nor do they traditionally factor in other cash flows, such as tax shelter and cost recovery (otherwise known as "depreciation"). Thus, capitalization rate valuation has become less important in real estate finance than it once was.

One advantage of capitalization rate valuation is that it is entirely independent from an "market-comparables" type of appraisal, and it is therefore often still used as a "reality check" on other value analysis.

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