Cap Rate Formula: Make Sure you Consider these Issues when Using it

cap rate formula

Understanding the issues in using the cap rate formula is very important because the capitalization rate represents a key figure in real estate investment analysis. This is the case because it measures the initial income return of an income-producing property at the time of acquisition (going-in cap rate for the investor buying the property) and it is a key figure in assessing its expected resale price at the end of the holding period of the investment (exit cap rate).  Furthermore, significant decreases in market cap rates over the holding period of the investment can contribute to strong capital gains, which are necessary in order to achieve double-digit investment returns.

The Cap Rate Formula

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 :

CRt = NOIt+1 / Pt

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 the property’s estimated market rent, 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. This data is 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 the next year but the current NOI for each property for the period for which the data is 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 factors that influence cap rates. They also differ 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.


Completely FREE 48-page e-book Real Estate Math for our visitors. Download it from this page of our site. No email address or anything else will be asked of you.


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.

Related Posts

Property Investment Basics: Capital Return
Cap rates and interest rates
The Cap Rate Cycle
Property Investment Basics: Real Estate Return Measures
Property Investment Basics: Return on Equity

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.

18 thoughts on “Cap Rate Formula: Make Sure you Consider these Issues when Using it

  1. Pingback: Apartment Cap Rates – Smart Property Investment
  2. Pingback: Net Operating Income (NOI) – Smart Property Investment
  3. Pingback: Smart Property Investing for High Returns – Smart Property Investment
  4. Pingback: How to identify property markets for capital gains? – Smart Property Investment
  5. Pingback: Going-in cap rate: How to calculate it for your next property investment
  6. Pingback: Capitalization rate: Make sure you know what it is and how to calculate it
  7. Pingback: Exit Cap Rate: A Key Figure in Estimating the Resale Price
  8. Pingback: Cap rate spread: Find out why it is a useful metric for real estate investors
  9. Pingback: Cap Rate Compression: How Much Cap Rates Can Fall?
  10. Pingback: Terminal Cap Rate: A Key Figure in Evaluating a Property Investment
  11. Pingback: Market Cap Rate: Alternative Techniques for Calculating it
  12. Pingback: Property Return Formula: A Tool for Strategizing -
  13. Pingback: Cap rate forecasts: Basic steps for forecasting cap rates econometrically
  14. Pingback: Discount Rate Formula: How to Apply it to a Property Investment
  15. Pingback: Difference between the Cap Rate and the Discount Rate
  16. Pingback: Los Angeles Apartment Absorption Rates - SMART PROPERTY INVESTMENT
  17. Pingback: Equity Capitalization Rate: An Important Investment Metric
  18. Pingback: Discount Rate, IRR and NPV in Evaluating Property Investments

Comments are closed.