What is the capitalization rate in Switzerland?
The capitalization rate is the ratio of the income to the value of a property, i.e. the rate of return. The cap rate expresses how much profit can be made with a particular investment over a specific period (typically one year).
Cap rate calculation example with formula
The capitalization rate is used in Switzerland in the valuation of income properties, i.e. all types of real estate that are not primarily intended for owner-occupancy but to generate rental income (e.g. blocks of flats, office buildings, and so on).
This valuation method is called the income approach. The value of an income property according to this approach can be easily calculated from the rental income and the cap rate rate using the following formula:
value = (net rental income / capitalization rate as a percentage) * 100
Say there is an income property for sale and the buyer's bank needs to estimate the value of the property to determine the amount of the mortgage. They will divide net rental income by the capitalization rate to obtain the value of the property.
If the property generates CHF 150,000 in net rental income and the capitalization rate is 5.0%, the property has a value of CHF 3,000,000 = (150,000 / 5) * 100. However, if the capitalization rate at an identical rental income is 7.5%, the property is only worth CHF 2,000,000 = (150,000 / 7.5) * 100.
As can be seen, the value of an income property depends on both the rental income and the capitalization rate. A high rental income and a low capitalization rate result in a higher value, while low rental income and a high capitalization rate result in a lower value.
How is the capitalization rate determined?
In Switzerland, the capitalization rate is typically determined by companies such as IAZI and Wüest Partner using hedonic methods. That is, the property to be valued is compared to other income properties in a database of historical transactions using statistical methods. This results in a cap rate which is appropriate for a particular property (based on its characteristics and in relation to the current market). These hedonic models are continuously validated and refined, and the underlying databases are constantly updated with data from recent transactions.
What does the capitalization rate actually indicate?
The capitalization rate ultimately indicates what ongoing costs are likely to be incurred for a particular property, expressed as a percentage of its value. The capitalization rate is higher when the expected costs are higher, and lower when the expected costs are lower.
Using the example above, if the annual rental income is CHF 150,000, then CHF 3,000,000 is the property value at which the rental income is exactly equal to the expenses, given annual expenses of 5% of the value.
From the investor’s perspective: If the rental income of an investment property is CHF 150,000, then an investment of CHF 3,000,000 results in precisely zero net profit, given ongoing costs of 5% of the value.
Another method for determining the capitalization rate
Besides statistical comparisons with historical transactions, the capitalization rate of a property can also be directly calculated, which can be useful when there are no comparable properties. In this case, all the incurred costs are added up, expressed as a percentage of the investment value.
As a baseline, a base interest rate corresponding to low-risk investment alternatives is used. To this, various surcharges for different risks are added, depending on the characteristics of the property. For example, block of flats in the centre of Zurich or Geneva naturally has a much lower risk of vacancy than an otherwise identical property in the countryside, because in the city the demand for apartments is much greater than the supply. Therefore, the surcharge for vacancy in the city will be smaller than in the countryside. Additional surcharges result from maintenance and administration costs. The higher these costs are likely to be, the higher the capitalization rate will be set.
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Capitalization rate in real estate in Switzerland: the key points
- The capitalization rate is the ratio of the income to the value of a property.
- The capitalization rate is used in the valuation of income properties (so-called income approach).
- The higher the capitalization rate, the lower the property value. The lower the capitalization rate, the higher the property value.
- The capitalization rate is typically determined using hedonic methods.