Cap Rate Calculation
Cap Rate = Net Operating Income (NOI) / Transaction Price
What is more complex is the determination of the numerator that enters the above formula. There is a discussion whether a «stabilized NOI» concept should be used or the estimated NOI of the first year of the investment holding period. Market capitalization rates are often estimated with the NOI of a building at the time of transaction.
The typical methodology for deriving a cap rate for a particular property is by estimating cap rates of transactions of comparable properties (same property type and other characteristics, to the extent allowed by available transaction data). However, because no property is exactly the same with another, the cap rate of each comparable is adjusted based on its differeces and their implications with respect to the risk profile of the property. For example, if the subject proeprty is located at a stronger location than the comparable property then the cap rate of the comparable is adjusted upwards to derive the cap rate for the subject property. Determining the magnitude of these adjustments is not easy, and they are left to the judgement of the appraiser based on his experience of variation of cap rates acros properties in the local market. Ideally, such adjustments need to be estimated through econometric models, but this is rarely feasible due to the lack of sufficient data for estimating such models.
Note that if the analyst is using, for example, five comparables then the cap rate calculation is likely to derive 5 different figures for the subject property by appropriately adjusting the cap rates of each of the comparable transactions. The final cap rate to be applied to the property can be calculated as the simple average of the five estimates, or as a weighted average by applying different weights each estimate from the different comparables based on the degree of similarity of each comparable to the subject, or the degree of the reliability of the comparable cap rate figure as perceived by the analyst.
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