CAP RATE CALCULATIONCap 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.
It should be noted that capitalization rates vary across property types. Furthermore, the cap rate that an investor will use to capitalize the NOI of a property in order to derive its value will depend on the risk associated with the income earning producing ability of the property. For example, the NOI of a building with very short term leases (1-3 years) to tenants with poor credit has a much higher risk than the NOI of a building with long-term leases (10-20 years) to tenants with very strong credit. Higher cap rates are used in the case of high-risk NOI and lower cap rates in the case of low-risk NOI. Thus, the cap rate calculation in the case of transactions involving high risk NOI should derive a higher result than in the case of transactions involving low risk NOI. 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 to 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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