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Learn how to define and determine capitalization (cap) rates


“What’s the cap rate?” “What cap rate should I use?” “What was the cap rate on that property?” “How do I get the cap rate?”

These are questions typically asked by real property developers, brokers and salespersons, appraisers, attorneys… almost everyone in the real estate business.

The first question to be answered is, “What is a cap rate?” Simply put, a capitalization rate is any rate used to convert income into value. It’s an investment metric or a tool that measures a property’s investment potential. It’s equivalent to the return “on” the investment.

Many of us recognize the overall capitalization rate (OAR) as the ratio of net operating income to sale price or value. But there are many other types of capitalization rates applied in this industry, depending on what you are trying to measure. For this article, the term “cap rate” is synonymous with the overall capitalization rate (OAR) because it’s the term typically used by market participants.

The basic formulas include:

Value = Income x Multiplier

or

or

Various scenarios demand the extraction of various types of rates, such as the land cap rate and building cap rate, mortgage cap rate and equity cap rate, leased fee and lease hold cap rate, terminal cap rate, and sandwich and sub-leasehold cap rate. Although all of these cap rates are important, it is the overall cap rate (OAR) that is generally sought after.

The two methods of income capitalization are (1) direct capitalization, in which a single year’s stabilized income is divided by an income rate or multiplied by an income factor to reach an indication of value, and (2) yield capitalization, in which future benefits are converted into a value indication by discounting them at an appropriate yield rate (this is known as a DCF analysis or discounted cash flow analysis).

So, where do these rates come from? OARs can be derived from comparable sales (you need to know the net operating income and the sales price), effective gross income multipliers and net income ratios, band-of-investment (need to know the mortgage and equity components), debt coverage formula, and several other methods that would take at least a day to explain. (In fact, there are appraisal classes spanning multiple days and countless texts and articles that focus primarily on OARs and other capitalization rates and yield rates.)

What’s the difference between a 7.5% OAR and a 12.0% OAR other than 4.5% or 450 basis points? The lower OAR indicates a CRE (commercial real estate) investment that is likely to increase in value due to several factors including increased rents, lower operating expenses, or lower vacancy. The 7.5% indicates an investment with a lower risk and a higher demand in the market. The 12.0% OAR is an indicator of a higher risk investment due to current supply of the particular CRE (oversupply of office property versus apartments), a high vacancy property, undesirable leases, or other external factors such as difficult financing, pending zoning changes, or changing economic conditions that may make the CRE less popular or even obsolete (special purpose properties).

Determining an OAR without first analyzing the property’s financial profile (income, vacancy, operating expenses), reviewing sales of similar properties with which cap rates can be extracted, and understanding any supply and demand issues associated with the property’s category (office, retail, warehouse, etc.) could be a disservice to you, your organization, or your client. There are professionals in the real estate industry who can assist in this process. These professionals are likely to have letters behind their names such as MAI (appraisers), CCIM (commercial real estate sales people), SIOR (industrial and office property experts), and others. These credentials represent time and study by these individuals, who in turn are sought after for their higher level of knowledge and experience.

Eric Lehmayer, MAI / MRICS / LEED AP, Director of Appraisal Services, High Associates Ltd.