Deriving Cap Rates

There are several acceptable methods for deriving capitalization rates for use in the income approach to property appraisal.  The following explains some of the more commonly used approached to cap rate derivation.

 

 

Direct Market Extraction: This approach simply obtains cap rates by examing the cap rates for sales comps.  It assumes that there is current, readily available net operating income and sale price information on comparable income-generating properties. The advantage with the market-extraction method is that the capitalization rate makes the direct income capitalization more meaningful.  The cap rates for the most recent and similar properties are given the most weight in this process.  Market cap rates may also be obtainined through interviews of appraisal professionals, brokers and investors.

 

 

Summation Technique: This approach combines market risk and reward measurements to obtain a cap rate.  For example, to obtain a cap rate, the following may be added together:

1) Expected Inflation Rate;

2) Real Rate of Return;

3) Risk Premium Rate; and,

4) Recapture Premium Rate. 

 

General Constant Growth Formula: Simply derives a capitalization rate by subtracting the growth rate of the economy from the IRR on equity.

 

(M x Rm) + (E x Re) = Ro

 

Band of Investment (Borrowing Cost & Rate of Return): This method presumes that a capitalization rate equates to a composite of debt and equity funds. This overall rate is extracted by deriving the weighted average of the mortgage capitalization rate and the equity capitalization rate. Market data components in this equation are the proportions of debt and equity in a typical deal and surveys of mortgage interest and equity return rates as well as actual market data for these components where available. The reliability of this method depends on the accuracy of the analyst's research and the disparity of rates between surveys and actual transactions.  The method derives an overall cap rate as follows: [(LTV x Mortgage Constant) + (ETV x required rate of return)]. 

 

Band of Investment (Land & Building): The band of investment calculation can be modified to incorporate land and building valuation metrics.  In so doing, the cap rate is derived as follows: [(Ratio of land value to total property value x Land Cap Rate) + (Ration of building value to total property value x Building Cap Rate)].