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CAP RATE FORMULA

The cap rate formula is simple. The formula is the following:

Cap Rate = Net Operating Income (NOI) / Transaction Price

According to textbook definitions (Greer and Farrell, 1992), the NOI used for the estimation of the cap rate, or the overall capitalization rate, is the projected net operating income of the property during the first year following its acquisition. Thus, taking into account the different time periods that the components of the cap rate formula refer to, the correct mathematical expression for this formula is :

CRt = NOIt+1 / TPt

Where:
CR= Cap Rate
TP= Transaction Price
t = year t, during which the transaction occurs
t+1= year t+1

The cap rate actually represents the income return to the investor that is acquiring a property. For example, the cap rate, of a transaction involving a property expected to produce an NOI of $100,000 in the first year of its holding period and is sold for $1 million, is:

Cap Rate = 100,000/1,000,000 = 0.10 = 10%

The estimated cap rate represents and the income return in the firs year of the holding period and that is why it is often referred to as initial yield.

Data Issues in Applying the Cap Rate Formula

Several vendors are providing cap rate data by market and property type as well as by individual transaction. The reported market cap rates may have not been estimated using the exact cap rate formula provided above, especially, if the cap rate has not been provided by the parties directly involved in the transaction (buyer or seller). It is more common to announce publicly the price at which a transaction occurred rather than the cap rate of the transaction. In such a case data vendors may find information about the current NOI of the property and estimate the transaction cap rate using that information and the publicly announced sales price.

Notice that projections of next year NOI can be quite complicated for multi-tenant commercial properties with many tenants. First of all coming up with projections of rental income requires looking at the leases of each tenant, figuring out whether there are annual escalation clauses, what percentage increase is applied to each lease and what particular date of the year. There may be also expiring leases in which case it is necessary to make some assumptions as to whether they will be renewed and, if not, how long the space will remain vacant. In addition, operating expenses will depend on how much space is occupied. For this reason, in most cases in applying the cap rate formula to current market transactions for deriving market capitalization rates, it is more likely to have data on the current NOI of the property at the time of the transaction rather than projections for next year. In many cases, even the former piece of information is not known and some data vendors may use in the cap rate formula an estimated NOI based on market rents, which is then applied to the announced sales price of a property to derive a “market capitalization rate”.

MATH FOR PROPERTY INVESTORS
AND REALTORS
Download all these formulas Now!
Internal Rate of Return(IRR)
The 3 Formulas for Modified IRR (MIRR)/Financial Management Rate of Return (FMRR)
Potential Gross Income Multiplier (PGIM)
Potential Gross Income
Effective Gross Income Multiplier
Effective Gross Income
Net Income Multiplier
Net Operating Income
Overall Capitalization Rate/Income Return
Capitalization Factor
Band-of-Investment Formula for Estimating a Market/Required Capitalization Rate
Theoretical-Approach Formula for Estimating a Market/Required Capitalization Rate
Appreciation Return
Total Return
Return on Total Capital (ROR)
Return on Equity (ROE)/Cash-on-Cash Return/Equity Dividend Rate
Before Tax Equity Cash Flow (BTECF)
Equity Investment
Loan Amount
Debt Service
Mortgage Constant
Payback Period
Breakeven Occupancy
After Tax Cash Flow (ATCF)
Taxable Income
One-Period IRR
Income Tax Payment in Association with Income Producing Property
Capital Gains
Formula for Cash Flow for Last Period of Analysis
Future Resale Price
Annual Rental Income of Occupied Multi-Tenant Property
Multi-Period Lease Rate Growth Formula with Intertemporally Variable CPI Forecast
Multi-period Lease Rate Growth Formula with Constant CPI Forecast
Present Value (PV)
Net Present Value (NPV)
Profitability Index
And more …….

Appraisal-Based Capitalization Rates

Appraisal-based (as opposed to transaction-based) cap rates are estimated for properties that have not been transacted recently, and as a result a transaction price is not available. As the term implies, with no transaction price available, the appraised value is used to derive a cap rate. In such cases the cap rate formula is modified as follows:

Cap Rate = NOI / Appraised Value

Appraisal-based cap rates do not reflect market capitalization rates as accurately as transaction-based cap rates, given that the transactions used for the estimation of the latter are normal arm’s length market transactions and there are no distortions of transacted prices for any reason. An example of appraisal-based capitalization rates are those provided by the National Association of Real Estate Investment Fiduciaries (NCREIF). NCREIF maintains income data (including NOI), appraised values and other data on properties held by its members that include most of the institutional property investors in the United States. These data are submitted by its members quarterly. Thus, NCREIF using these data provides estimates of appraisal-based capitalization rates. However, notice that as NCREIF does not have projections of NOI for next year but the current NOI for each property for the period for which data are submitted. Furthermore, the appraised values reported for a given quarter, may represent the result of valuations carried out in previous quarters, as institutional investors do not appraise their properties every quarter. Given these data limitations, the cap rate reported by NCREIF is estimated using current NOI as opposed to next year’s NOI.

When using market cap rates provided by vendors investors need to have in mind that these vary by property type, within property type (according to product quality), by location and other attributes that influence cap rates, as well as across markets and within markets. Thus, when trying to derive a cap rate to be applied to a specific property, market cap rates for the corresponding property type should be adjusted to reflect the idiosyncratic advantages and risks of the property considered.




Related Posts
Cap Rate Data Sources
Historical Cap Rate Measurement Issues
Capitalization Rate Estimation Techniques
Cap Rates and Interest Rates
Exit Cap Rate
Cap Rate Cycle
Apartment Cap Rates
Capitalization Rate Influences
Capitalization Rate Readings

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