How do you find a capitalization rate?

Answer 1

The capitalization rate is dependent on what investors want to earn on their money when investing in commercial real estate. It is somewhat tied to the prevailing interest rates as investors can choose other choices if real estate does not provide a sufficient return.

You compute the prevailing rate if you divide the price a property is being offered at by the NOI (Bet Operating Income). Each building could vary but there should be a level that is common for most buildings that are in the same market (type, condition and location). Many times the NOI can be misstated so check the details to see what has been assumed when the NOI was computed. Garbage in, garbage out otherwise.

Knowing how to find a cap rate is easy once you know exactly what one really is. You probably have heard of a PE ratio in stocks. A PE ratio of 18 means the stock is selling for 18 times earnings. With earnings per share of 2.00, the stock would be selling for 2.00 x 18 $36 per share.

Well, a cap rate is the inverse of a PE ratio and it is used in real estate instead of the Stock Market.

For example, lets look at a PE ratio of 8. Earnings per share 1.00. The stock would sell for 1.00 x 8 $8 per share.

Now real estate, same 8 multiple. The inverse of 8 1/8 12.5% (cap rate). Annual earnings per square foot 1.00. Since a cap rate is the inverse of a PE ratio, you divide instead of multiply. 1.00 / .125 $8 per square foot of market value.

So, a cap rate expresses the relationship between earnings (net income in real estate) and market value. In real estate text books, cap rates are expressed with the letter R. Net Income is the letter I and market value is the letter V. Using simple algebra, there are three ways to express this relationship:

V I / R

I V x R

R I / V

Ooops... that last formula tells you where to find capitalization rates (the original question).

Simple. Find some sales of properties. Find out what their net income was at the time of sale. Divide that income by the sale price. That gives you a cap rate. Do that with 5 sales and you will have a range of cap rates. Give the greatest weight to the sales which are the most comparable to the subject property being appraised and you will have a weighted average cap rate you can use to "capitalize" (divide) your subject's pro forma net income (over the next 12 months) into a current market value.

One last comment -- a bit technical -- but if you don't know the net income of the sales you can take each sale's asking rent, less observed vacancy at the time of sale and estimate the cap rate with the following formula. (Note: you will need to know the typical operating expense ratio (OER) for that property type of that age. Brokers and property owners can tell you this. For example, many multifamily properties have OERs in the 35 to 40% range -- depending on age, condition, location, etc.)

Formulas:

First calculate Effective Gross Inc Multiplier (EGIM) Sale Price / (Gross Rent Less Vacancy) ... then you can calculate the Cap rate (1 - OER) / EGIM

Let's put some numbers on it to make sense:

Gross Rent 1.00

Vacancy 10%

Eff Gross Inc 0.90

Sale Price 7.00

EGIM 7.00 / 0.90 7.7778

OER is assumed to be 38% based on local info from brokers.

Overall Cap Rate (OAR) (1 - .38) / 7.7778 7.97%

Now let's apply the cap rate to prove it works:

Value Net Inc / OAR (V I / R)

Effective Gross 0.90

Operating Expenses 38% of that, or 0.342

Net Inc .90 - .34 .56

Value .56 / 7.97% 7.00 (Look back at the beginning Sale Price... 7.00)