Capitalization rate vs. Recapture rate
The capitalization (cap) rate is the rate of return the investor wants on a property; it consists of the return on the investment plus the recapture (through depreciation) of the investment.
Capitalization (CAP) rate — The percentage selected for use in the income approach to valuation of improved property. The CAP rate is designed to reflect the recapture of the original investment over the economic life of the improvement to give the investor an acceptable rate of return (yield) on his or her original investment and to provide for the return of the invested equity. In other words, if the property includes a depreciating building, the CAP rate provides for the return of invested capital in the building by the end of the economic life (the recapture rate that allows for the building’s future depreciation) and the return on the investment in the land and the building (similar to yield).
Example: If a building has a 50-year economic life, then the recapture rate is set at 2 percent per year. If the rate of return on the investment is 8 percent and the recapture rate is 2 percent, then the overall capitalization rate applicable to the building is 10 percent.
The selection of an appropriate CAP rate is influenced by the conditions under which the particular investment is being operated, as well as the availability of funds, prevailing interest rates, risk and so on. Only an experienced appraiser can select the appropriate CAP rate—a mere 1 percent difference in the suggested CAP rate could make a 12 percent difference in the value estimate.
The CAP rate measures the risk involved in an investment. Thus, the higher the risk, the higher the CAP rate; the lower the risk, the lower the CAP rate.
Recapture rate — An appraisal term describing that rate at which invested capital will be returned over the period of time a prudent investor would expect to recapture his or her investment in a wasting asset.