How to Calculate a Market Cap Rate

market cap rate

The market cap rate is the prevailing capitalization rate used by active investors in a particular marketplace in order to derive the value of a particular property using the direct income capitalization approach.

In essence, the market cap rate represents the average income return required by active investors in the marketplace for a real estate asset of particular quality/location and property type. The direct income capitalization technique is used quite often by investors for a preliminary estimation of the value of a particular property based on its net operating income (NOI),  per the following formula:

Property Value = Annual Net Operating Income / Market Capitalization Rate

Property investors and analysts should have in mind that this calculation is very sensitive to the market capitalization rate used in the denominator of the formula. For example, the use of a 4.5% market capitalization instead of a 5% would result in a considerably higher property value. Therefore, in using this technique even for the estimation of an indicative value for a  real estate investment, it is of utmost importance to use the best possible estimate of the market capitalization rate for the particular property under consideration.

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 their overall riskiness as property investments.

 

Estimating a Market Cap Rate Using Comparables

Within this framework, the appropriate market cap rate is typically determined by analyzing capitalization 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, cap 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 = Annual Net Operating Income / Value

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 $21,000 will be:

V = 21,000 /0.08 = 262,500

Estimating a Market Cap Rate Using the Band-Of-Investment Technique

If enough good sales comparables cannot be found to come up with a reliable estimate of the appropriate market cap rate then a theoretical/ mathematical approach can be used alternatively. The band-of-investment technique is such an approach but it requires the use of a market equity rate for the specific type of property valued. This rate refers to the equity return that would be required by an investor for investing in the specific property at the given location. The estimation of an appropriate equity rate for a given property is not easy and it has to take into account the market-required rate of return for the risk level that characterizes the property under consideration, given its type, location, and idiosyncratic characteristics.

The formula for estimating the appropriate market cap rate with the band-of-investment  technique is the following:

C = (Equity Percentage x Equity Rate) + (LTV Ratio x Debt Rate)

Where

LTV = Loan Amount / Property Value
Equity Percentage = 1 – LTV
Equity Rate = Equity return required by equity investors for investments of similar risk
Debt Rate = Total Return required by lender (see below)

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 following formula, where i is the loan rate and n the term of the loan, can be used for calculating the mortgage constant (MC):

MC = i /( 1- [1/(1+i )n ] )

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

In theory, the capitalization rate is the required income return by the investor and is given by the following formula:

Cap rate =  Total required returnCapital return expectation

The total required return from investors in the marketplace is the sum of the following 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 for 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 about 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 riskier 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 total required return by property investors in particular marketplace in which the four components have the following values:

Inflation 3.0%
Real return 2.0%
Risk premium 3.0%
Recapture premium 1.8%
Expected annual property value appreciation rate: 2%

Total required return = 3%+2%+3%+1.8% = 9.8%

Cap rate = 9.8% – 2% = 7.8%

Although this theoretical approach for calculating capitalization rates can provide a solution when sales data for comparable properties are not available, the analyst should contrast the results of such estimates against available market capitalization rate data, even if they refer to the broader market area in which the property operates. Furthermore, the analyst should consult with local real estate investment professionals and get a range of capitalization rates in the local market within which the property is located.

Author: Petros Sivitanides, Ph.D.

Dr. Sivitanides is a seasoned expert in real estate investment strategy and analysis, property portfolio modeling and strategic analysis, and real estate market research and econometric forecasting with over 16 years of experience with leading global real estate investment managers and real estate consultants (CBRE Global Investors, AXA Real Estate, Torto Wheaton Research, DTZ, etc.). He is the editor of the textbook titled “Market Analysis for Real Estate”, which has been used as the main textbook for a graduate course at Harvard University. He is also the author of the book "Real Estate Investing for Double-Digit Returns" and many widely quoted articles that have been published in popular real estate journals. Currently, he is the Head of the Real Estate Department at Neapolis University in Cyprus, and an international real estate consultant.

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