A capitalization rate ("cap rate") is the
**
interest rate
**
at which earnings,
**
dividends,
**
or cash flows are converted into value or equity. (The root word of
capitalize is capital, meaning equity interest.) A confusing
aspect of the term "cap rate" is that some people use it to
mean a whole number to multiply against the earnings measure, whereas
others interpret it as an interest rate by which an earnings figure is
divided. Mechanically, the conversion of earnings to capital is done by
either dividing or multiplying the selected earnings figure by the cap
rate appropriate under the circumstances. The conversion formula will be
one of the following:

(Where cap rate is stated as an interest rate)

or

(Where cap rate is stated as a multiple)

Since the more common use of the term is as an interest rate to be divided into an earnings figure, the remainder of this essay will use cap rate in that context. To think of it in the reverse, simply take the reciprocal.

Another confusion about cap rates is that they are occasionally used
interchangeably with
**
discount rates.
**
They are differentiated by the fact that the discount rate is applied to
a series of adjusted future earnings figures, whereas cap rates are
applied to a static measure of earnings.

The cap rate is a function of the riskiness of the subject earnings, considering volatility, the time horizon, and the size of the entity involved. The greater the risk, the higher the cap rate will be, thus the lower the capitalized value, and vice versa. This is because given identical cash flows or earnings, investors will place a lower value on those whose future receipt is perceived as riskier; that is, they will be more deeply discounted. Low-risk ventures, on the other hand, will have their earnings discounted only mildly, as there is less uncertainty about the return to the investor.

Probably the most common example to illustrate the cap rate concept is the
**
stock market's
**
price to earnings multiple (the
**
"price/earnings ratio,"
**
or P/E ratio): the reciprocal of this multiple is the market's cap
rate for that equity issue. As an example, if a company's
**
stock
**
is trading at $40 per share and its earnings per share (EPS) is forecast
at $2.50, the P/E ratio is 16. Since the cap rate we have defined is the
reciprocal of the P/E ratio, it equals 1/16, or. 0625 (6.25 percent).

Care must be exercised when applying cap rates to make sure that factors
such as
**
inflation,
**
growth rates, and maturity are understood and properly taken into
consideration. For example, cap rates calculated by reference to market
rates of return are usually stated in nominal terms and therefore include
an element representing inflation. Since the amount of earnings or cash
flow being capitalized is static, it is stated in real terms, which means
that it does not include escalation for future inflation. In this case,
the cap rate has to be converted into a real basis by subtracting an
estimate of inflation from the observed nominal rate.

Another situation to be wary of is when the cap rate is determined by
reference to comparable companies, such as taking the reciprocal of the
stock market P/E ratio. The stock market includes expectations about
future earnings, including the estimated rate of growth in earnings in its
determination of market price. P/E ratios will often be significantly
affected by the market's expectation of future growth rates of
earnings. For example, two companies with similar earnings and similar
**
risk
**
characteristics may have vastly different growth prospects, due to some
outside factor such as
**
management
**
skill or favorable contractual arrangements. The company with the faster
growth prospects will have a lower cap rate to divide into its earnings,
therefore, other things being equal, will have a higher value.

Ideally, cap rates are applied to forecasted earnings or cash flows. This follows logically since value is based on future, not past, outcomes. As a result, one has to be careful when drawing inferences from published P/E ratios. Most P/Es are calculated using "trailing" or the prior year's earnings. Many investment research houses calculate P/Es based on forecasted earnings.

[
*
Christopher
*
*
C.
*
*
Barry
*
,

*
updated by
*
*
Ronald
*
*
M.
*
*
Horwitz
*
]

Fabozzi, Frank J., ed.
*
Handbook of Portfolio Management.
*
New York: McGraw-Hill, 1998.

Also read article about **Capitalization Rate** from Wikipedia

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