The equity capitalization rate is the capitalization rate that reflects the relationship between the income of the property and the equity investment committed to the property.
This is also referred to as the cash on cash rate, cash flow rate, or equity dividend rate. The formula for estimating the equity cap rate (ECR) is the following:
ECR = Before Tax Cash Flow (BTCF) / Investor Equity
BTCF = Net Operating Income (NOI) – Debt Service
Investor Equity = Acquisition Price – Loan Amount
The market-required equity cap rate can be used to convert property income into an equity market value indication by solving the above formula for Investor Equity:
Investor Equity Value = BTCF / ECR
Using the same formula a particular investor can use in the denominator his/her own required equity return to determine the price that would provide that return.
The equity cap rate enters also the estimation of market cap rates using the band-of-investment technique and represents the return on equity demanded by the investor.
To demonstrate with numbers the calculation of the equity capitalization rate consider the case of a property producing an annual net operating income (NOI) of £100,000. The property was bought at a price of £1,000,000 with 80% financed through a fixed-rate mortgage loan with a 6% interest rate and 20 year term. To calculate the equity capitalization rate we need to estimate first the Before Tax Cash Flow (BTCF).
BTCF = Net Operating Income – Debt Service
The annual debt service for a fixed-rate loan of £800,000 (80% of purchase price) with a 6% interest rate and 20 year term is £69,747.65. Therefore the annual BTCF equals:
BTCF = 100,000 – 69,747.65 = £30,252.35
Investor equity in this transaction is 20% of purchase price, that is, £200,000. Therefore the ECR is:
ECR = 30,252.35 / 200,000 = 15.1%