Capitalization Rate

Theory

      The Income Approach is often the most important method of analysis for determining value of income properties.  By definition, the two things from which value is determined using the Income approach are Net Operating Income (NOI) and Capitalization Rate (Cap Rate) because  Value = NOI/Cap Rate.  Accordingly, understanding capitalization rates and knowing how to determine what rate to use for a particular property is absolutely necessary to determining value by the Income approach.
      The cap rate is usually significantly greater than the interest rate that an investor might accept for a safe passive investment such as a Certificate of Deposit.  In general, the cap rate for a particular investment can be defined as the rate that investors expect from that particular investment taking into account the risk, liquidity, and management burden.  In other words,

        Safe Rate (minimum risk - e.g., CD)      S  %

        Add for additional risk                           R

        Add for non-liquidity                             N

        Add for management burden                 M
                                                                   ----
              Rate applicable to investment        Total %

      Thus, we see why the rate used in valuation of income property will be in excess of the safe rate.  Although the above provides illustration, it is not usually a valid way of determining cap rates because the additive terms are not themselves usually calculable.  We might also subtract a rate based on the tax benefits derived from the investment, but this would introduce an even more complex variable due to the extreme variability of tax brackets.  Even though the above calculation cannot normally be used in the real world, it does tell us that we should expect to use a higher cap rate for properties that are extremely  management intensive or in a questionable location and that we should expect the cap rate to come down as the safe rate decreases.
      There are a couple of ways to determine the cap rate that you should use for your analysis.  If you know a good appraiser well enough, you can ask him what the current rate is for the specific type of property under consideration.  The advantage of this way is that it is very easy.  The disadvantage is that a  particular appraiser may not have available the correct cap rate for the particular type of property.  For example, if an appraiser has worked on nothing except large regional shopping centers for the past year, he may have less idea than you regarding what the current proper rate should be for a 10-unit apartment building in the suburbs.  Similarly, your real estate agent will probably have an opinion as to the correct cap rate.  However, again, unless he can back up his opinion with some analysis of current market data, you must resist going the easy route.  Keep in mind that calculated value will be directly inversely related to the cap rate used.  For example, using a cap rate that is low by 10 percent will give a value this is high by 11 percent - $22,000 high on a $200,000 property.
      The bottom line is that you should know how to determine the proper rate on your own and spend the necessary time to do so.  Even for small properties, using a low cap rate can cost thousands of dollars.  For larger properties, a low-cap-rate error can amount to many tens of thousands of dollars.  Thus, performing the necessary research and analysis can easily earn you hundreds of dollars per hour for your efforts.
      Cap rates can be derived by several theories, including the Band of Investment, Direct Comparison, and Comparison of Quality Attributes theories.  For real estate investment, the most commonly used and simplest method of determining the current capitalization rate is by analyzing recent sales of similar properties - the Direct Comparison method.  For this we will need to know both the sale price and the NOI for each comparable property.  In the real world, determining the NOI of comparable properties can be difficult because the necessary data may not be easily available.  Because of the difficulty in obtaining the necessary information for comparables, it is recommended that you include as many comparables as possible in your analysis so as to average out the errors resulting from inaccurate data.
      For our example in this lesson, we will assume that you have a real estate agent who obtained the data for you, that your friendly neighbor is a certified appraiser, or that you managed to gather the information yourself and then calculated the NOI for each property.  We will not actually calculate the NOIs for the comparables.  We will be doing a detailed analysis of NOI for our subject property in the next lesson and determining the NOIs for the comparable of this lesson would be done exactly the same way.

Example

      For our example we assume that the subject property is the same 4-plex that we used for our Reserve Account analysis of Lesson 5 and that we have gathered the following information about four recent sales.

      While we could utilize income, vacancy, and expense numbers to calculate NOI for each comparable, we will be doing that when we use the Income Approach analysis in Lesson 7, so we will simply list the NOI for each here.

     We include the 3-plex because it has about the same size units as the subject property, is a very recent sale, and is more comparably located than any of the other properties.
      You will note that we have included data about each property  (age, distance, sale date, etc.) that could be used to weigh the results.  That is, the cap rate could be influenced more by some comparables than others when reconciling the results.  However, for our example, we will simply average the four numbers (divide the sum of them by 4) to obtain a capitalization rate of 9.27 percent, rounded to 9.3 percent.