CAPITALIZATION RATES
Capitalization rates (or cap rates, as commonly referred to in the real estate investment community) represent one of most important pieces of information in terms of commercial property valuation and pricing. See here summary of the latest mortgage rate forecast.
Within this context, market capitalization rates represent very important indicators in understanding property market pricing and real estate capital market trends. To better understand what these rates are see the article below.
Investing in any specific property requires collection of the most reliable real estate market data, including cap rate data, and thorough analysis of all relevant aspects of the property under consideration and the market within which it operates.
Within this context market cap rate data represent a very important piece of information when trying to value an income property or evaluating a real estate investment opportunity. For these reasons it is crucial for real estate investors to understand the forces that drive movements in cap rates and where to find data on prevailing real estate market trends with respect to this indicator.
When reviewing relevant real estate market data, investors need to be aware of measurement issues as reported numbers may be based on appraisals as opposed to actual transaction prices, or estimates of Net Operating Income (NOI) as opposed to actual building NOI. You can gain a basic understanding of the capitalization rate and how it can be estimated with real estate market data by reading the article below.
Cap Rate Estimation Techniques
The capitalization rate, or cap rate, is a factor that translates property income into an estimate of property value. This value estimation technique is referred to in the appraisal literature as the direct income capitalization approach. A more sophisticated income capitalization methodology is the Discounted Cash Flow (DCF) model that takes into account the property’s projected income (both from rents and resale of the property at the end of the holding period) and expenses to estimate the value of the property as the present value of the net cash flow discounted by the investor’s required annual return (income return plus appreciation return) over the holding period. The formula for the estimation of a property’s value (V) using the capitalization rate is:
V = Net Operating Income / Capitalization Rate (1)
Notice that when the above formula is used in a typical discounted cash flow model to estimate the resale price of the property at the end of the holding period, then the capitalization rate entered in the formula is referred to as an "exit cap rate". Thus, the first step in valuing a property using the capitalization rate is to assess its ability to produce income, and particularly its Net Operating Income (NOI). A property’s NOI is estimated as the difference of the total income the property produces (from rents and other sources, such as parking fees), minus operating expenses. Typical expenses involved in operating a property include real property taxes, hazard, insurance, utilities, reserves, maintenance and management.
The NOI can be estimated by constructing an operating statement for the subject property. Let’s see an example of an apartment building with 20 units, 10 one-bedroom units renting for $1,000 per month and 10 two-bedroom units renting for $1,500 a month. Based on market information we also know that the annual occupancy rate for apartment buildings in the neighbourhood of the property under consideration is 5%. Furthermore, we know that annual operating expenses amount to 25% of gross rental income. Let’s see how the operating statement will look like:
Gross Rental Income
10 units x $1,000 x 12 $120,000
10 units x $1,500 x 12 $180,000
Total Gross Rental Income $300,000
Minus
Vacancy Losses 5% $15,000
Effective Gross Income $285,000
Minus
Operating Expenses 25% $75,000
Net Operating Income $210,000
The next step in applying the direct income capitalization approach is to determine the appropriate market cap rate to be used for the estimation of the value of the subject property. This is necessary because market cap rates vary both across property types and through time. Furthermore, since no single property is exactly the same with another property cap rates vary even across individual properties in a way that reflects their differences in terms of the factors that affect their value and risk profile.
Using Comparables
Within this framework the appropriate capitalization rate is typically determined by analyzing cap rates for sales transactions involving comparable properties in the area of the subject property. Subsequently the appraiser needs to “reconcile” these rates by weighting them on the basis of the differences of the comparables from the subject property in terms of location, condition, amenities, income-earning capacity, creditworthiness of tenants, occupancy rate, etc. Obviously, capitalization rates involving sales of properties that are more similar to the property under consideration will be given greater weighting. Based on the value formula given above capitalization rates for comparable sales can be estimated as:
Capitalization Rate = Net Operating Income / Value (2)
Thus, the capitalization rate for an apartment building that produces an NOI of $16,000 and sold for $200,000 is 16,000/200,000= 0.08. When estimating market capitalization rates from comparables, extra caution is needed to ensure that the NOI data used for each property are accurate and that they have been estimated in a consistent way across transactions. Once the appropriate market cap rate is determined through the analysis of adequate comparable sales, the property can be valued using that capitalization rate. So, if for example the analyst determines that the appropriate market cap rate is 0.08 then the value of the apartment building in our example that produces an NOI of $210,000 will be:
V = 210,000 /0.08 = 2,625,000
Using the Band of Investment Technique
If enough good sales comparables can not be found to come up with a reliable estimate of the appropriate market capitalization approach then a theoretical/mathematical approach can be followed to come up with an appropriate cap rate. The band-of-investment technique is such an approach but it requires the use of a market equity cap rate for the specific type of property valuated. This rate refers to the equity return that would be required by an investor for investing at the specific property at the given location. The estimation of an appropriate equity rate for a given property is not easy. Assuming that the analyst comes up with an estimate of such a rate that he/she feels comfortable with, then the formula for estimating the appropriate capitalization rate with this technique is: C = (Equity Percentage x Equity Rate) + (LTV Ratio x Debt Rate)
Notice that, in the formula above, LTV stands for loan to value ratio and is calculated as the ratio of the amount of the loan over the value of the property. So for example if the loan amount is 75% of the value of the property then the LTV is 0.75. The equity rate is the percentage of the value of the property that is not financed by loan but by the investor’s own money. So if the LTV is 0.75 then the equity percentage is 0.25. We have already explained what the equity rate is and for the sake of this example we will assume that it is 12%. The debt rate is the total return required by the lender and is NOT the interest rate of the loan, because it also includes and the return of the lenders capital. The debt rate entering the band-of-investment approach is actually the mortgage constant. The formula for calculating the mortgage constant (MC) is: MC = i /( 1- [1/(1+ i ) n ] ) where i is the loan rate and n the term of the loan. So for a 20-year loan at an 8% interest rate the mortgage constant would be: MC = 0.08/( 1- [1/(1.08 ) 20 ] ) = 0.101852 Now, we have in our example all the numbers needed to apply the band-of-investment technique to estimate the cap rate: Capitalization rate = (0.25 x 0.12) + (0.75 x 101852) = 0.03 + 0.076 = 0.106
Theoretical Approach for Estimating Cap Rates
In theory the capitalization rate is the sum of four components: 1) Expected Inflation 2) Real Return 3) Risk Premium 4) Recapture Premium By definition, an investment is the commitment of capital in exchange of a monetary benefit, or a return. Investors require a return on the capital invested as a prerequisite for committing capital to a given venture or property. This required return should first provide for the preservation of the purchasing power of invested capital through time. Hence, the first component of required return is expected inflation, so that the purchasing power of invested capital will not decline through time. Ideally, this component is estimated based on inflation rate forecasts, however, many analysts use an average inflation rate over the past five or ten years. The second component of required return is the real return, which is the true monetary benefit that the investor will gain from committing his/her capital. This is typically estimated as the difference between the rate on government securities and the inflation rate. According to estimates over the past decades this component ranges between 2 and 3 percent.
A property investment is actually an investment in the property’s future income earning capacity. However, there is a lot of uncertainty with this future income earning capacity. For example, tenants may stop paying rent for financial or other reasons; or market rents may decline and new tenants will sign at lower rent; or, even worse, the landlord may not be able to replace tenants vacating the building. In this respect property investments have risk. This risk is the uncertainty associated with the future income stream and the value of the property. Within this context, real estate investors require a risk premium on top of inflation and real return. The risk premium for a given property depends on the quality of the tenants occupying the property, the length of existing contracts, the property’s occupancy rate, the strength of the property’s location and expectations regarding the prospects of the economy and the local real estate market. For example, the future income stream of an office building with poor-credit tenants is more uncertain and, therefore, more risky than the future income stream of an office building with strong-credit tenants. In addition, the future income stream of an office building in a metropolitan area whose economy is expected to be growing rapidly has less uncertainty and, therefore, less risk than the income stream of an office building in a metropolitan area whose economy is expected to be declining. Likewise, the income stream of a property in a market expected to be facing increasing vacancy rates is more uncertain and more risky than the income stream of a property in a market expected to be facing declining vacancy rates. Another component of the risk premium attached to real estate investments is liquidity risk, that is, the risk of liquidation or converting the property to cash. Because selling a piece of real estate at its fair market value is a lengthy and, in many respects, uncertain process, unless a significant price discount is provided, the liquidity risk for property investments is considered high. There has been a lot of discussion in the professional and academic real estate community about the appropriate risk premium for different property types. Based on historical data it appears that the lower risk premium is associated with apartment investments and the highest with office investments. For the sake of our example we will use a 3% as the risk premium. Finally, investors require and a recapture premium in the case of property investments, since properties depreciate or lose value through time. Since the value of the property represents the owner’s invested capital, it follows that by the end of the physical life of a building, when its value becomes theoretically zero, the investor loses its capital. The purpose of the recapture premium is to replace this capital loss through time. Thus, if the physical life of a property is 50 years the recapture premium should be 2% on an annual basis. If we assume though that the capital that is recaptured every year is reinvested (sinking fund approach) then a less than 2% recapture rate will be required. Based on this discussion, let us estimate the capitalization rate as the sum of these four components: Inflation 3.0% Real return 2.0% Risk Premium 3.0% Recapture premium 1.8%
Capitalization Rate 9.8%
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