The capitalization rate is of great importance when planning financial or investment activities. At the same time, in Russia, the capitalization rate cannot always be determined with reliable accuracy. This is due to the fact that information from various markets comes incomplete. In addition, often it is not entirely true. What is a capitalization rate?
What is a capitalization rate?
This indicator is the ratio of the value of the property to the income that it can bring during the year. The capitalization rate allows the investor to assess the prospects of investing money in a particular asset. There are several types of this indicator. By analyzing each of them, you can better understand the characteristic features of capitalization rates.
Characteristic indicator
For example, a risk-free capitalization rate provides for the direction of investments in those assets for which at least a return on investment is guaranteed. As far as we know, investing without risks practically does not exist. In this case, we mean investments such that the probability of unpleasant accidents is reduced to zero.
An example of such an investment is investment, the guarantor of which is the state or a reliable bank from Switzerland. At the same time, market risks are inextricably linked with financial instruments such as stocks, bonds and other securities. The income from such investments directly depends on the success of the issuing company.
Investors were the first to feel the low profitability of a business for investing their own funds in securities. But not only this type of financing is accompanied by risks. For example, real estate is traditional and one of the most reliable ways of investing. Nevertheless, this asset is also prone to risks such as low liquidity, depreciation during operation, as well as changes in legislation, including tax.
Methods for calculating the capitalization rate
What are the calculation methods for the capitalization rate? There are several of them:
- cumulative construction;
- related investments;
- market squeeze method;
- Inwood's method and others.
In practice, the most common is the cumulative construction method. What are the components of the capitalization rate? This method uses the principle of summing a risk-free rate indicator, a market risk premium, and a risk premium associated with investing in a specific asset. What does it mean? In other words, in order to predict the likely profit, it is necessary to take into account such indicators as the risk-free rate, the total level of market risks and the degree of risk relative to a particular asset.
Real Estate Capitalization Rate
In the process of analyzing the likely profitability of investing in real estate, investors calculate the profit that they can get during its operation. This method allows you to predict the effect of the investment and compare the purchase price of the object with revenue.
The capitalization rate for real estate is calculated using a formula that is derived from the following equation:
V = I / R, where:
- V is the value of the property;
- I - the estimated profitability from the operation of the facility;
- R is the capitalization rate of real estate.
Accordingly, the capitalization rate: R = I / V.
It should be noted that the income capitalization rate is sometimes also called the capitalization ratio, capitalization rate or net rent multiplier. These terms are synonyms. The calculation of this indicator is quite effective and objective. This is due to the fixed cost of real estate, which sets the market and which can be found from open sources. In addition, the rental price of real estate is also regulated by the market, which simplifies the task.
The principles of calculating the capitalization rate for real estate
It must be emphasized that when calculating the profitability of an object, the required expenses should be deducted from the total revenue. These include:
- payment for electricity;
- payment for object security;
- salaries of various employees;
- other costs associated with the process of operation of real estate.
In addition, from the parameter I it is necessary to subtract the lost profit due to the lease of not all 100% of the building. Also, expenses that reduce the overall profitability include taxes, interest on loans and other fixed costs. And only after deducting all costs, we get a net operating income, which is used in the formula for calculating the capitalization rate of real estate.
Having received all the necessary data, we can calculate the required indicator according to the above formula. Consider an example. Suppose you invest in a type of real estate such as storage space. The cost of the facility is 50 million rubles. After deducting all costs, the investor determines that the net operating income will be 13 million rubles per year. To determine the capitalization rate for real estate, you must use the formula: 13 million / 50 million = 0.26. This value shows that every year the investor will receive 26% of their investment from the rental of storage facilities.
Choosing the property with the highest capitalization rate
When choosing an immovable property for investing money, preference should be given to those that have the highest capitalization rate. In addition, it should be noted that without taking into account such a coefficient, it is impossible to predict the effectiveness of investments and evaluate the object before its acquisition. It also requires market analysis and tracking of important economic indicators based on available data on real estate investments.
In the process of full monitoring, the information received should be generalized. At the same time, it is necessary to evaluate various segments of the real estate market. Subsequently, this information will serve as a guide and will allow for a correct assessment of the facility. In addition, it makes it possible to carry out a qualitative comparative analysis of the available calculated indicators and average figures for the market.
Linked Investment Method
Often, the amount of equity and borrowed capital is used to purchase real estate. Therefore, for the correct calculation of the capitalization rate, it is necessary to consider both sources of investment. How to calculate the indicator? In this case, the direct investment method, or, as it is also called, the technique of the investment group, is used to determine the capitalization ratio. Moreover, the capitalization rate formula for credit funds is as follows:
Rm = DO / IR, where:
- Rm - capitalization ratio of borrowed funds, or mortgage constant;
- DO - annual payments on borrowed funds;
- IR is the main amount of a mortgage loan.
In this case, the capitalization rate for equity is calculated using the formula as follows:
Re = DP / K, where:
- Re is the rate of return on equity;
- DP - cash flow for the year before payment of all taxes;
- K is the amount of equity.
The total capitalization rate when using the direct investment method is determined by calculating the weighted average of the first two indicators: P = M x Pm + (1 - M) x Re, where M is the part of the loaned funds in the total cost of the object.
Market Squeeze Method
This method involves the use in calculating the capitalization rate of the indicator of net operating income from the activities of a similar company or from its real estate, as well as from the sale value of its assets. To determine the capitalization ratio using the market squeeze method, it is necessary to divide the net operating income by the cost of a similar object or company.
What does it mean? In other words, to determine the capitalization rate of the desired company, indicators of the basic formula for the capitalization ratio are used, but for another similar company that occupies the same market segment and is comparable in size. A characteristic feature of this method of calculation is the lack of accounting for return on investment and the return on investment.
This technique has both advantages and obvious disadvantages. The positive characteristics include the relative simplicity of determining the capitalization ratio. A bet calculated in this way has its drawbacks. For example, the disadvantages include the lack of necessary data regarding the net operating income and sales value of the company, which is taken as the basis for the analysis. Therefore, it is not always possible to select the correct and suitable examples.
Inwood Method
This method is used in cases where, according to the forecast, during the entire investment cycle, the return on investments will be equal. At the same time, part of the income represents the return on investment, and the other is the return on invested capital. The amount of capital recovery is reinvested. This takes into account the rate of return on investment. It is possible to determine the capitalization rate on the condition of obtaining equal revenue by obtaining the sum of the return on investment rate and the return fund factor for the same percentage.