What is a Capitalization Rate?

A capitalization rate is essentially a rate that is utilized to convert income into some sort of value that is realized on the asset. Perhaps the easiest way to think of a capitalization rate is to consider the ratio between the original cost of acquiring an asset in comparison to the amount of income that is produced by the asset within a specified time frame. From this perspective, capitalization rates can be though of as a ratio on earnings associated with the ownership of the asset.

Calculating a capitalization rate follows a very simple process. Essentially, knowing the capital cost of the asset, as well as the total amount of revenue generated by the asset within a given period of time is all that is needed. By calculation the ratio between the two figures, the capitalization rate for the asset is determined.

A capitalization rate may be calculated from the point of acquisition through the current date, or for any period between the two. Some investors like to calculate the rate for specific financial periods, such as monthly or quarterly. Comparing the results can indicate if there has been a change in the capitalization rate from one period to the next, which may help the investor determine if it is worth the effort to hang on to the asset.

Understanding the capitalization rate as it relates to normalized earnings can also help the investor to project the future earnings that can be anticipated from the asset. In making future projects, the investor may also want to play around with a discount rate of capitalization, basing the figure on the calculated rate from different periods and using the average. As part of the process, the investor may want to take into account different factors that could impact the capitalization rate in future periods. Among these factors would be fluctuations in the stock market, changing economic conditions, shifts in consumer preferences, and increased competition in the marketplace.