Market capitalization rates are the capitalization rates that characterize the market on the basis of recent property investment transactions at any given point in time. If adequate data exist, capitalization rates can be estimated from market transactions by dividing each property’s Net Operating Income (NOI) over the property’s sales price.
Otherwise other estimation techniques need to be used. Specialized vendors do provide market cap rate estimates by property type for major markets in the US.
The estimation of accurate market cap rates for a given market from current transactions needs to account for differences not only in the types of properties involved in these transactions, but also for any other differences among properties (physical, locational, financial, etc.) that may affect property risk and return characteristics. Thus, it is necessary to not only estimate cap rates for a given market by property type, but also ensure that the estimated cap rates from each property within the same property type are adjusted accordingly (upwards or downwards) to reflect their differences. This is not an easy task, as each property transacted is unique in its internal,external and other characteristics.
Estimating Market Capitalization Rates
Beyond the great heterogeneity among properties transacted, the estimation of accurate market cap rates for a given area from market transactions is not an easy task for a number of reasons:
1) The smaller the market the smaller the number of transactions available and the less accurate the estimate, as it may not fulfill minimum requirements of an adequate statistical sample of homogeneous property transactions
2) Most of the time, the official sales price of a transaction is known very well, but usually very little is known regarding the terms and financial structuring that are backing such a sales price in order to evaluate whether non-typical monetary costs or benefits are included in the deal, which would imply a higher or lower true market price
3) The most common inaccuracies though hidden in estimates of capitalization rates based on market transactions are those related to one of the two most important property-specific pieces of information needed to estimate a capitalization rate: the NOI of the property involved in the transaction. The NOI of the property involved in a market transaction is rarely announced and is a very difficult piece of information to estimate for a particular property, especially if it is a multi-tenant one, unless it is provided by the owner of the building. In light of this problem, many capitalization rate estimates are using announced sales prices and estimated NOI for each property for which a sales price is available, not the actual NOI of the property for which the sales price is known. Such NOI estimates are based on market rents for the type and quality of property analyzed.
What Determines Market Capitalization Rates
Market capitalization rates are determined in the property investment market based on the interaction between the demand for property investments and the supply of property investments. When demand exceeds the supply of property investments, investors will need to bid up prices, thereby pushing market cap rates down. If the supply of property investments exceeds demand, the property owners will need to reduce there prices thereby pushing market capitalization rates up.
Demand for property investments is influenced, among others, by performance of alternative investment vehicles, such as stocks and bonds, as well as by interest rates and expectations of property market performance. For example, when stocks and bonds returns worsen relative to property returns more capital will flow to property. Assuming a fixed supply of property investments, such increased capital flows will push market cap rates down, all else being equal. See a more detailed discussion of all factors that affect movements in market capitalization rates here