Business and finance terms can appear nearly identical in meaning and definition while ultimately referring to different things. This proves true with overall rate of return (OAR) and capitalization rates – on the surface, no difference exists between these two terms. However, OAR differs from capitalization rates when it comes to the appropriate and accurate application of these terms. Understanding the differences between these terms requires a brief examination of their meanings and applications.
OAR denotes an overall rate of return, also known as overall capitalization rate. The term relates specifically to real estate and displays a ratio demonstrating the rate at which the income made from a property reaches its purchase price. To calculate OAR, divide the net operating income by the price. For instance, assume you buy a building for $500,000 and earn a net operating income of $50,000 per year on it. OAR equals 50,000/500,000 or .10. Because 50,000 divides into 500,000 10 times, the income earned from a property eclipses the price of the building after 10 years.
Capitalization rates describe the rate at which tangible assets lose value. A tangible asset constitutes anything of value and physical form, such as a building, equipment, computers and vehicles. Organizations calculate lost value through capitalization rates to write the value off on taxes. For instance, if a company purchases a vehicle with a 20-year lifespan, accountants use capitalization rates to calculate the lost value on the vehicle once it dies. This amount comprises a tax write off.
Most obviously, OAR applies exclusively to the world of real estate investment while capitalization rates is a more generic term. OAR qualifies as a form of capitalization rate applied to a property. Any tangible asset with a finite life space theoretically possesses a capitalization rate, because it necessarily becomes useless at some point due to its finite nature. Tangible assets lose all value upon becoming useless. Furthermore, capitalization rates other than OAR exist even in the world of real estate -- direct capitalization rates, for example.
Differences in Capitalization Meaning
The word capitalization holds a different meaning in its generic form than in the case of OAR. In real estate, capitalization rates compare the income earned on a property each year to the purchase price of the property. This rate predicts the point at which income earned eclipses the purchase price, thus paying off the value of the building. In almost all other applications, capitalization refers to the point at which an investment loses value.
- John M Francis Appraisal: Overall Capitalization Rates
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