The cap rate formula is simple:

Cap Rate = Net Operating Income (NOI) / Transaction Price

According to textbook definitions (Greer and Farrell, 1992), the NOI used for the estimation of the cap rate, or the overall capitalization rate, is the projected net operating income of the property during the **first year** following its acquisition. Thus, taking into account the different time periods that the components of the cap rate formula refer to, the correct mathematical expression for this formula is :

CR_{t} = NOI_{t+1} / P_{t}

Where:

CR= Cap Rate

P= Transaction Price

t = year t is the year during which the transaction occurs

t+1= the year following year t

The cap rate actually represents the **income return to the investor** that is acquiring a property. For example, the cap rate, and, therefore, the income return of a property expected to produce an NOI of $100,000 during the first year of its holding period and is sold for $1 million, is 10%. The other component of total property investment return is the capital return, which is calculated on the basis of the change of the value of the property during its holding period.

**Data Issues in Applying the Cap Rate Formula**

Several vendors are providing cap rate data by market and property type as well as by individual transaction. The reported market cap rates may have not been estimated using the exact formula provided above, especially, if the cap rate has not been provided by the parties directly involved in the transaction (buyer or seller). It is more common to announce publicly the price at which a transaction occurred rather than the cap rate of the transaction. In such a case, data vendors may find information about the current NOI of the property and estimate the transaction cap rate using that information and the publicly announced sales price.

Notice that projections of next year NOI can be quite complicated for multi-tenant commercial properties with many tenants. First of all, coming up with projections of rental income requires looking at the leases of each tenant, figuring out whether there are annual escalation clauses, what percentage increase is applied to each lease and what particular date of the year. There may be also **expiring leases**, in which case some assumptions need to be made as to whether they will be renewed and, if not, how long the space will remain vacant. In addition, operating expenses will depend on how much space is occupied. For this reason, in most cases in applying the cap rate formula to current market transactions for deriving market capitalization rates, it is more likely to have data on the current NOI of the property at the time of the transaction as opposed to projections for next year. In many cases, even the latter piece of information is not known and some data vendors use an **estimated NOI** based on market rents, which is then applied to the announced sales price of a property to derive a “market capitalization rate”.

**Appraisal-based capitalization rates**

Appraisal-based (as opposed to transaction-based) cap rates are estimated for properties that have not been transacted recently, and thus a transaction price is not available. Due to the lack of a transaction price, an **appraised** value is used to derive a cap rate. In such cases the cap rate formula is modified as follows:

Cap Rate = NOI / Appraised Value

Appraisal-based cap rates do not reflect market cap rates **as accurately** as transaction-based cap rates, given that the transactions used are normal arm’s length market transactions. An example of appraisal-based capitalization rates are those provided by the National Association of Real Estate Investment Fiduciaries (NCREIF). NCREIF maintains income data (including NOI), appraised values and other data on properties held by its members that include most of the institutional property investors in the United States. These data are submitted by its members quarterly. Thus, NCREIF provides estimates of appraisal-based capitalization rates that are calculated from this data. Notice that NCREIF does not have projections of NOI for next year but the current NOI for each property for the period for which data are submitted. Given these data limitations, the cap rate reported by NCREIF is estimated using current NOI as opposed to next year’s NOI. Furthermore, the appraised values reported for a given quarter may represent the result of valuations **carried out in previous quarters**, as institutional investors may not appraise their properties every quarter.

When using market cap rates provided by vendors, investors need to have in mind that these **differ by property type, within property type (according to product quality), by location and other attributes** that influence cap rates, as well as across markets and within markets. Thus, when trying to derive a cap rate to be applied to a specific property, market cap rates for the corresponding property type should be **adjusted to reflect the idiosyncratic advantages and risks** of the property considered.

### References

Kolbe, P. T., & Greer, G. E. (Author), Gaylon E. Greer. (2012). Investment Analysis for Real Estate Decisions, 8th Edition. Dearborn Real Estate Education.

Sivitanides, P. 2008. *Real Estate Investing for Double-Digit Returns*. BookSurge Publishing.

Geltner, M., Miller, N. G., Clayton, J., & Eichholtz, P. (2013). *Commercial Real Estate Analysis and Investments (with CD-ROM)*. Oncourse Learning.

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