Capitalization Rates and Yield Rates: Understanding Returns and Risks

Chapter: Capitalization Rates and Yield Rates: Understanding Returns and Risks

Introduction

This chapter delves into the critical concepts of capitalization rates (cap rates) and yield rates within the context of income capitalization. Understanding these rates is paramount for accurately valuing income-producing properties and assessing the associated risks and returns. We will explore the theoretical underpinnings, practical applications, and the interplay between these rates and market dynamics.

1. Defining Capitalization Rates and Yield Rates

• Capitalization Rate (Cap Rate): A rate that expresses the relationship between a property’s Net Operating Income (NOI) and its value or price. It essentially represents the unleveraged rate of return an investor can expect from a property’s income. The formula is:

  • R = NOI / Value

  Where:
  * R is the Capitalization Rate
  * NOI is the Net Operating Income (annual)
  * Value is the property’s market value or price
  * Yield Rate: A rate of return on capital, typically expressed as a compound annual percentage rate. It considers all expected future benefits, both positive and negative, over the entire investment horizon, including the proceeds from the sale of the property (reversion). Yield rates are used in yield capitalization, also known as discounted cash flow (DCF) analysis.

2. Return on Capital vs. Return of Capital

A crucial distinction lies between the return on capital and the return of capital.

• Return on Capital: The profit or income generated by the investment. This is the investor’s compensation for tying up their capital and for the risk associated with the investment.
• Return of Capital: The recovery of the original investment. This happens through the sale of the property (reversion) or implicitly through the periodic income stream if the property maintains its value.

In yield capitalization, the separation between return on and return of capital is explicit. The yield rate discounts future cash flows, implicitly accounting for both the return on the invested capital over the holding period, and the return of the invested capital when the property is eventually sold.

In direct capitalization, cap rates implicitly incorporate both the return on and the return of capital. The cap rate must reflect a price that allows the investor to earn a market rate of return on their investment while also providing for the eventual recapture of their capital.

Example: Consider a property purchased for \$1,000,000 generating \$80,000 in NOI annually. If the resale value is expected to remain at \$1,000,000, the entire income can be attributed to the return on capital. The cap rate would be 8% (\$80,000 / \$1,000,000).

3. Income Rates: Overall, Equity, and Mortgage Capitalization Rates

• Overall Capitalization Rate (R_o): As defined above, relates the NOI to the total property value. It reflects the relationship between a single year’s NOI and the total property price or value.

• Equity Capitalization Rate (R_e): Relates the cash flow available to the equity investor (Cash Flow After Debt Service) to the equity investment. It’s the “cash-on-cash” return. The formula is:

  • R_e = Cash Flow After Debt Service / Equity Investment
  • Mortgage Capitalization Rate (R_m): The ratio of the annual debt service to the original loan amount. It reflects the lender’s return on and return of the loaned capital.

4. Discount Rates and Yield Rates: A Deeper Dive

• Discount Rates vs. Capitalization Rates: While both are used to convert future income into present value, they differ significantly in how they handle future income and value changes. Discount rates explicitly account for anticipated changes in income or value within the cash flow projections. Capitalization rates, on the other hand, implicitly account for these changes within the rate itself.
• Overall Yield Rate (Y_o): Also known as the property yield rate or unleveraged rate. It represents the rate of return on the total capital invested, considering all changes in income over the investment projection period and the reversion at the end. It doesn’t consider the impact of debt financing; it assumes the property is purchased with all cash.
• Equity Yield Rate (Y_e): The rate of return on equity capital. It’s the equity investor’s internal rate of return (IRR). It is affected by financial leverage (the use of debt), and is thus called a levered rate.
• Mortgage Yield Rate (Y_m): Represents the lender’s internal rate of return on the mortgage loan.

5. Estimating Rates: Market Extraction and Band of Investment

Estimating appropriate capitalization and yield rates is a critical step in the income capitalization approach.

• Market Extraction: The most common and reliable method. It involves analyzing comparable sales to extract implied capitalization or yield rates. This is done by solving the cap rate or yield rate formula using market data:

  1. Collect Data: Gather sales data on comparable properties, including sale price, NOI, and relevant property characteristics.
  2. Calculate NOI: Determine the stabilized NOI for each comparable property.
  3. Calculate Implied Cap Rate: Divide the NOI by the sale price for each comparable: R = NOI / Sale Price.
  4. Analyze and Reconcile: Analyze the extracted cap rates, considering differences in property characteristics, location, and market conditions. Reconcile the data to arrive at a supported cap rate for the subject property.
  5. DCF Analysis: Collect data on comparable properties to extract implied Yield Rates. Run a DCF Model for each comparable property. Enter Cash Flows from operations as well as reversion values. Change discount rate in order to match the comparable properties’ market prices. The discount rate that makes the discounted cashflows equals to the sales price is the property’s IRR or Yield Rate.

• Band of Investment: A technique used to develop an overall capitalization rate based on the weighted average of the returns required by the debt (mortgage) and equity components of the investment. The formula is:

  • R_o = (L/V * R_m) + (E/V * R_e)

  Where:
  * L/V is the Loan-to-Value ratio
  * R_m is the mortgage capitalization rate (annual debt service / loan amount)
  * E/V is the Equity-to-Value ratio (1 - L/V)
  * R_e is the equity capitalization rate

  Example: A property is financed with a 70% loan at 6% interest, and the equity investor requires a 10% return. The overall capitalization rate would be: (0.70 * 0.06) + (0.30 * 0.10) = 0.042 + 0.03 = 0.072 or 7.2%.
  While the band-of-investment concept can be helpful in understanding these components, especially in differentiating marginal risk considerations. While they can be used to approximate market-extracted rates, they should not be represented as market-extracted rates.

6. Factors Influencing Capitalization and Yield Rates

Numerous factors influence the appropriate capitalization and yield rates for a property. These factors reflect the market’s perception of risk and the opportunity cost of capital.

• Perceived Risk: Higher risk investments require higher rates of return. Risk factors include:
  • Tenant quality
  • Lease terms
  • Property condition
  • Market volatility
  • Economic conditions
• Market Expectations Regarding Future Inflation: Higher expected inflation generally leads to higher required rates of return, as investors seek to maintain their real purchasing power.
• Opportunity Cost: The rate of return available on alternative investments. If comparable investments offer higher returns, investors will demand a higher rate for the subject property.
• Rates of Return Earned by Comparable Properties: This is the basis of market extraction. What are investors currently accepting for similar properties?
• Prevailing Tax Laws: Tax laws can significantly impact after-tax returns and influence investment decisions.
• Availability of Debt Financing: The cost and availability of debt financing can impact both the equity investor’s required return and the overall capitalization rate.
• Market conditions, prevailing interest rates, and the time value of money: These also cause changes in capitalization rates over time.

7. Risk, Inflation, and Value

• Risk: Risk is the uncertainty of receiving projected future economic benefits. Higher risk demands higher returns. Appraisers must analyze market evidence and use the rate that is consistent with the level of risk associated with receiving the economic benefits.
• Inflation and Value: Appreciation in real value is the result of an excess of demand over supply which increases property values beyond the level of inflation. The amount of inflation expected affects the forecast of future benefits and the estimation of an appropriate income or yield rate. A distinction must be made between expected inflation and unexpected inflation.

• Nominal vs. Real Rates:

  • Nominal Rate: The stated rate of return, which includes an inflation premium.

  • Real Rate: The rate of return after adjusting for inflation. The approximate relationship is:

    • Real Rate ≈ Nominal Rate - Inflation Rate

  Most investors seek to protect their real rate of return over time.

8. Procedure: Applying Income Capitalization Techniques

The income capitalization approach involves two basic methods: direct capitalization and yield capitalization.

• Direct Capitalization: Uses a single year’s income (typically the next year’s projected NOI) and a market-derived overall capitalization rate to estimate value.

  1. Estimate the property’s stabilized Net Operating Income (NOI).
  2. Obtain a market-derived overall capitalization rate (R_o) from comparable sales.
  3. Apply the formula: Value = NOI / R_o.

• Yield Capitalization (Discounted Cash Flow Analysis): Considers a series of cash flows over a projected holding period, along with the estimated reversion value (sale price) at the end.

  1. Project the property’s cash flows (NOI) for each year of the holding period.
  2. Estimate the property’s reversion value (sale price) at the end of the holding period.
  3. Determine an appropriate discount rate (yield rate) that reflects the risk and opportunity cost of the investment.
  4. Discount each future cash flow and the reversion value back to present value.
  5. Sum the present values of all cash flows and the reversion to arrive at the indicated value.
     The formula for Present Value (PV) is:
     • PV = CF1/(1+r)^1 + CF2/(1+r)^2 + … + CFn/(1+r)^n + RV/(1+r)^n
       Where:
       • CF1 is Cashflow of Year 1
       • r is discount rate
       • n is the last year
       • RV is the reversion value.

9. Practical Applications and Experiments

• Scenario Analysis: Varying the assumptions regarding income growth, expense ratios, and discount rates in a DCF model to understand the sensitivity of value to different market scenarios.
• Sensitivity Analysis: The goal of sensitivity analysis is to determine the impact on the Net Present Value (NPV) of varying one or more variables. This will help determine whether the variables you are examining have a material effect on the result. It will also illustrate the variables to which the NPV is most sensitive.

• Rent-Up Adjustment: Calculating an adjustment to the value indication to account for the cost of leasing up a property with vacancies.

  • Calculate the cost of tenant improvements (TI)
  • Calculate the cost of leasing commission
  • Calculate the lost revenues during the rent-up period
  • Determine the length of the rent-up period in which you want to recapture the costs. Divide the total costs by the revenues of the rent-up period in order to determine the percentage of rent-up costs.
  • Subtract the calculated percentage of rent-up costs from the property’s value

• Case Studies: Analyzing real-world examples of property valuations using both direct and yield capitalization methods.

• Back Solving Techniques: Use an actual market sales transaction to analyze the reliability of the value drivers. For example, solve for the implied Growth Rate, Cap Rate, or Discount Rate to see how those value drivers are related and how they might influence value depending on changes in the marketplace.

10. Conclusion

Capitalization rates and yield rates are fundamental concepts in income capitalization. A thorough understanding of their theoretical foundations, estimation techniques, and the factors that influence them is essential for accurate property valuation and sound investment decision-making. By applying these concepts with careful analysis and consideration of market conditions, appraisers and investors can effectively assess the risks and returns associated with income-producing properties.