capitalization rate

Tags - #Financial_Freedom, #Financial_Management, #Definition, #Examples

⚠ The capitalization rate reflects the liking of the investors for a company.

If the company earns a higher rate of earning per share through risky operations or risky financing pattern, the investors will not look upon its shares with favor. If a company invests its fund in risky ventures, the investors will put in their money if they get higher return as compared to that from a low risk share. The market value of a firm is a function of the earning per share and the capitalization rate.

β–Ά Example: Suppose the earning per share is expected to be $7 for a share, and the capitalization rate expected by the shareholder is 20 per cent, the market value of the share is likely to be

7/20% = 7 x 100/20 = $35

This is so because at this price, the investors have an earning of 20%, something they expect from a company with this degree of risk.

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Examples of Capitalization Rate

Assume that an investor has $1 million and he is considering investing in one of the two available investment options – one, he can invest in government-issued treasury bonds that offer a nominal 3 percent annual interest and are considered the safest investments and two, he can purchase a commercial building that has multiple tenants who are expected to pay regular rent.

In the second case, assume that the total rent received per year is $90,000 and the investor needs to pay a total of $20,000 towards various maintenance costs and property taxes. It leaves the net income from the property investment at $70,000. Assume that during the first year, the property value remains steady at the original buy price of $1 million.

The capitalization rate will be computed as (Net Operating Income/Property Value) = $70,000/$1 million = 7%.

This return of 7 percent generated from the property investment fares better than the standard return of 3 percent available from the risk-free treasury bonds. The extra 4 percent represents the return for the risk taken by the investor by investing in the property market as against investing in the safest treasury bonds which come with zero risk.

Property investment is risky, and there can be several scenarios where the return, as represented by the capitalization rate measure, can vary widely.

For instance, a few of the tenants may move out and the rental income from the property may diminish to $40,000. Reducing the $20,000 towards various maintenance costs and property taxes, and assuming that property value stays at $1 million, the capitalization rate comes to ($20,000 / $1 million) = 2%. This value is less than the return available from risk-free bonds.

In another scenario, assume that the rental income stays at the original $90,000, but the maintenance cost and/or the property tax increases significantly, to say $50,000. The capitalization rate will then be ($40,000/$1 million) = 4%.

In another case, if the current market value of the property itself diminishes, to say $800,000, with the rental income and various costs remaining the same, the capitalization rate will increase to $70,000/$800,000 = 8.75%.

In essence, varying levels of income that gets generated from the property, expenses related to the property and the current market valuation of the property can significantly change the capitalization rate.

The surplus return, which is theoretically available to property investors over and above the treasury bond investments, can be attributed to the associated risks that lead to the above-mentioned scenarios. The risk factors include: