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Deriving Capitalization Rates: Methods & Applications
Chapter: Deriving Capitalization Rates: Methods & Applications
Introduction
Capitalization rates (cap rates) are a fundamental tool in direct capitalization, a valuation technique used to convert a single year’s income expectancy into an estimated property value. Understanding how to derive accurate and reliable cap rates is crucial for making sound investment decisions and for appraisal purposes. This chapter delves into various methods for deriving cap rates, exploring their theoretical underpinnings and practical applications.
1. Direct Extraction from Comparable Sales
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Principle: The most straightforward method involves analyzing recent sales of comparable properties. The cap rate is calculated by dividing the property’s Net Operating Income (NOI) by its sale price.
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Formula: RO = NOI / Sale Price
- Where:
- RO = Overall Capitalization Rate
- NOI = Net Operating Income (for the year following the sale)
- Where:
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Scientific Basis: This method assumes that the market participants’ collective judgment about future income potential is reflected in the sale price. By analyzing several comparable sales, an appraiser can identify a trend or range of cap rates applicable to the subject property.
- Practical Application:
- Data Collection: Gather data on comparable sales, including sale prices, verified NOIs, and property characteristics. The NOI should be carefully scrutinized and normalized for any unusual expenses or income items.
- Example: A small single-tenant industrial building on Main Street sold last month for $555,000 with a NOI of $55,000. Another building on Adams Street sold three months ago for $625,000 with a NOI of $62,500. These two properties yield cap rates of 9.91% and 10%, respectively.
- Analysis:
- Calculate the cap rate for each comparable sale.
- Adjust the derived cap rates based on the differences in the property characteristics.
- Select a single rate or a narrow range that reflects the market expectations.
- Limitations:
- Data Availability: Finding truly comparable sales with reliable income data can be challenging.
- Future Income Potential: Direct extraction assumes that the future income potential of the comparable properties is similar to that of the subject property. If the subject’s upside potential is significantly different, the extracted cap rate may be skewed. This is especially true if the subjectโs rent is increasing by 4% per year while the comparable has a level income due to a lease.
- Market Efficiency: This method relies on the assumption that the market is relatively efficient and that sale prices accurately reflect income potential.
2. Derivation Using Income Ratios
- Principle: This method employs the Effective Gross Income Multiplier (EGIM) and the Net Income Ratio (NIR) to derive the cap rate.
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Formula: RO = NIR / EGIM
- Where:
- RO = Overall Capitalization Rate
- NIR = Net Income Ratio (NOI / Effective Gross Income)
- EGIM = Effective Gross Income Multiplier (Sale Price / Effective Gross Income)
- Scientific Basis: It leverages the relationship between gross income, net income, and market value.
- Practical Application:
- Data Collection: Obtain data on EGIM and Expense Ratios for comparable properties. The Net Income Ratio can be calculated by subtracting the Expense Ratio from 1 (NIR = 1 - Expense Ratio).
- Example: If a property has an EGIM of 5.5 and an Expense Ratio of 52%, the NIR is 48% (1 - 0.52). The cap rate would be calculated as 0.48 / 5.5 = 0.087273 or 8.73%.
- Limitations: This method is rarely used in practice because sufficient income and expense data to determine the NIR are usually enough to derive NOI directly.
- Where:
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3. Band of Investment Technique
- Principle: This approach divides the overall capitalization rate into components based on the capital structure of the investment, typically mortgage and equity.
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Formula: RO = (M ร RM) + ((1 - M) ร RE)
- Where:
- RO = Overall Capitalization Rate
- M = Loan-to-Value Ratio (mortgage ratio)
- RM = Mortgage Capitalization Rate (mortgage constant)
- RE = Equity Capitalization Rate
- Scientific Basis: This method acknowledges that most real estate investments are financed with both debt and equity. The weighted average of the required return on each component reflects the overall required return on the investment.
- Practical Application:
- Data Collection: Obtain information on prevailing mortgage rates, loan-to-value ratios, and investor expectations for equity returns. The mortgage constant can be calculated by dividing the Annual Debt Service (ADS) by the initial mortgage amount.
- Mortgage Constant (RM) Calculation: The mortgage constant, RM, can be calculated using a financial calculator:
- Input: n (number of payment periods), i (interest rate per period), PV (present value of the loan), FV (future value of the loan, usually 0).
- Solve for PMT (payment).
- RM = PMT ร number of payment periods per year / PV
- Example: A lender quotes a 10% annual interest rate with monthly payments for 25 years. Using a financial calculator, the monthly mortgage constant is 0.009087. Multiplying by 12 yields an annual mortgage constant of 0.10904. If the equity capitalization rate is 13% and the loan-to-value ratio is 75%, the overall rate is: (0.75 ร 0.10904) + (0.25 ร 0.1300) = 0.11428 or 11.43%.
- Limitations: The accuracy of this method depends on the reliability of the estimated equity capitalization rate. The equity capitalization rate is the ratio of the first yearโs income to the capital amount paid. This is very different if there are substantial changes in the future.
- Small changes in the equity capitalization rate can significantly impact the overall cap rate, especially when the equity component is small.
- Where:
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4. Land and Building Residual Technique
- Principle: This technique applies different capitalization rates to the land and building components of a property and then combines them to derive the overall cap rate.
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Formula: RO = (Land Ratio ร RL) + (Building Ratio ร RB)
- Where:
- RO = Overall Capitalization Rate
- RL = Land Capitalization Rate
- RB = Building Capitalization Rate
- Land Ratio = Land Value / Total Value
- Building Ratio = Building Value / Total Value
- Scientific Basis: This method recognizes that land and buildings have different economic lives and risk profiles. Land generally appreciates over time, while buildings depreciate.
- Practical Application:
- Data Collection: Determine the land-to-building ratio for comparable properties. Estimate the land and building capitalization rates based on market conditions and property characteristics.
- Example: A property has a 25:75 land-to-building ratio. The land capitalization rate is 9%, and the building capitalization rate is 13%. The overall capitalization rate is (0.25 ร 0.09) + (0.75 ร 0.13) = 0.12 or 12%.
- Limitations: This is a theoretical analysis because the rights in realty, not land and buildings, are sold. It is common way to look at real estate and is the basis of the cost approach.
- Where:
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5. Debt Coverage Ratio (DCR) Formula (Mortgage Underwriter’s Method)
- Principle: This method derives the overall capitalization rate directly from mortgage lending parameters.
- Formulas:
- DCR = NOI / ADS
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RO = M ร RM ร DCR
- Where:
- DCR = Debt Coverage Ratio
- NOI = Net Operating Income
- ADS = Annual Debt Service
- RO = Overall Capitalization Rate
- M = Loan-to-Value Ratio
- RM = Mortgage Capitalization Rate (mortgage constant)
- Scientific Basis: It acknowledges the significant role of debt financing in real estate investments. The DCR reflects the lender’s comfort level with the property’s ability to cover debt service obligations.
- Practical Application:
- Data Collection: Obtain information from lenders on prevailing mortgage rates, loan-to-value ratios, and required DCRs for the specific property type.
- Example: A lender quotes a 75% loan-to-value ratio, a 9% annual interest rate, and a 1.2 DCR for a 20-year loan. The annual mortgage constant for a 20-year loan at 9% is 0.10797. Therefore, RO = 0.75 ร 0.10797 ร 1.2 = 0.09717 or 9.72%.
- Limitations: The lender’s requirements and the prevailing market conditions influence this rate. Lender interest may represent 80% or more of the property value, so the use of their parameters is probably valid. This method does not fully account for buyer inputs. The reported DCRs are driven by individual banks and might not be consistent in the market. It is an excellent technique to affirm a capitalization rate obtained from another source.
- Where:
- Formulas:
6. Surveys
- Principle: Utilization of surveys conducted by real estate research firms that report capitalization rates is another viable method.
- Scientific Basis: The surveys aggregate data from institutional investors, providing a general overview of market trends.
- Practical Application:
- Data Collection: Acquire relevant real estate surveys and broker reports.
- Analysis: Use the survey information, understanding it could require adjustment based on the location or property type.
- Limitations: Data from surveys may not be relevant to a local real estate market.
7. Residual Techniques (Land and Building Residual)
- Principle: These techniques are used to estimate property value when specific data points are known (e.g., net income, land value, land and building capitalization rates).
- Practical Application: These techniques solve for unknown values when other components are available, such as land and building capitalization rates.
Conclusion
Deriving capitalization rates requires careful analysis, sound judgment, and a thorough understanding of market conditions. Each method has its strengths and limitations, and appraisers should use a combination of approaches to arrive at a well-supported estimate. By mastering these techniques, professionals can confidently apply direct capitalization to make informed decisions and provide accurate property valuations.
Chapter Summary
This chapter, “Deriving Capitalization Rates: Methods & Applications,” within the “Mastering Direct Capitalization: A Comprehensive Guide” training course, focuses on methodologies for determining capitalization rates (cap rates) and their application in real estate valuation through direct capitalization.
The central scientific point is that direct capitalization utilizes a single year’s net operating income (NOI) and a capitalization rate to derive a lump-sum value indication. The validity of this technique relies heavily on selecting an appropriate and representative cap rate. Several methods for deriving cap rates are presented, each with its own strengths and weaknesses.
Methods for Deriving Capitalization Rates:
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Extraction from Comparable Sales: This is the preferred method. It involves identifying recent sales of comparable properties and calculating their cap rates by dividing their NOI by their sale prices (RO = NOI / Sales Price). A crucial consideration is ensuring the comparable properties exhibit similar future income potential and expense characteristics as the subject property. Any differences in upside potential or income patterns must be carefully considered and adjusted for.
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Effective Gross Income Multiplier (EGIM) and Net Income Ratio (NIR): If EGIM and NIR are known, the formula RO = NIR / EGIM can be used. However, the chapter suggests that this method is not as practical as the data needed to find EGIM and NIR usually includes all the information needed to find the NOI.
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Band of Investment (Mortgage and Equity): This method partitions the overall cap rate into mortgage and equity components. The formula is: RO = (M x RM) + ((1 - M) x RE), where M is the loan-to-value ratio, RM is the mortgage constant (annual debt service divided by the initial loan amount), and RE is the equity capitalization rate. This technique heavily weights the readily available market mortgage rate. Challenges arise in accurately estimating the equity capitalization rate, which can fluctuate significantly.
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Band of Investment (Land and Building): This technique utilizes the land-to-building ratio along with land and building cap rates to estimate the overall cap rate: RO = (Land Ratio x RL) + (Building Ratio x RB), where RL is the land capitalization rate and RB is the building capitalization rate. Though theoretically sound, it emphasizes the separate valuation of land and buildings instead of the property right itself.
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Debt Coverage Formula (Mortgage Underwriters Method): This method leverages data directly from mortgage lenders, acknowledging the significant role of financing in property sales. The formula is RO = M x RM x DCR, where DCR is the debt coverage ratio (NOI / Annual Debt Service). While seemingly market-oriented, its reliability hinges on the lender’s lending practices and potential biases, thus must be used with care.
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Surveys: Capitalization rates reported by real estate research firms and brokers can provide supporting evidence, although the survey data’s source, derivation methods, and local market relevance should be carefully evaluated.
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Residual techniques: allow appraisers to estimate the value of property if the net income, land value, and land and building values are known.
Conclusions and Implications:
- Direct capitalization is a simplified valuation approach best suited for properties with stable income streams and predictable expenses.
- The accuracy of direct capitalization hinges on the appropriateness of the selected cap rate.
- Multiple methods exist for deriving cap rates, each requiring careful consideration of its underlying assumptions and data requirements.
- No single method is universally superior; appraisers should utilize a combination of approaches and reconcile the resulting cap rate estimates.
- Thorough market research, including analysis of comparable sales, lender data, and market surveys, is crucial for deriving reliable cap rates.
The chapter emphasizes that appraisers are usually required to reconcile various capitalization rates found in the market, highlighting the need for professional judgment and expertise in applying these techniques. A key implication is that a deep understanding of these derivation methods allows appraisers to develop well-supported and credible property valuations using direct capitalization. The common problem related to reserves for replacements and tenant improvement expenses were raised in order to emphasize its importance when calculating comparables.
