The cap rate calculation is used in the context of applying the income approach to valuing a property. The formula for the cap rate calculation is simple:
Cap Rate = Net Operating Income (NOI) / Transaction Price
What is more complex is the determination of the numerator that enters the above formula. There is a discussion whether a «stabilized NOI» concept should be used or the estimated NOI of the first year of the investment holding period. Market capitalization rates are often estimated with the NOI of a building at the time of transaction. It should be noted that capitalization rates vary across property types. Furthermore, the cap rate that an investor will use to capitalize the NOI of a property in order to derive its value will depend on the risk associated with the income earning producing ability of the property. For example, the NOI of a building with very short term leases (1-3 years) to tenants with poor credit has a much higher risk than the NOI of a building with long-term leases (10-20 years) to tenants with very strong credit. Higher cap rates are used in the case of high-risk NOI and lower cap rates in the case of low-risk NOI. Thus, the cap rate calculation in the case of transactions involving high risk NOI should derive a higher result than in the case of transactions involving low risk NOI.
Calculating the Cap Rate to be Applied to a Specific Property
When it comes to deriving a rate to be applied to a specific property, the cap rate calculation is not an easy task at all. This is the case because property is highly heterogeneous. Properties differ in many respects including, but not limited to, quality, size, construction quality, space layout and functionality, technological equipment, location, income-earning prospects, age, location, etc.
The typical methodology for deriving a cap rate for a particular property is by estimating cap rates of transactions of comparable properties (same property type and other characteristics, to the extent allowed by available transaction data). However, because no property is exactly the same with another, the cap rate of each comparable is adjusted based on its differeces and their implications with respect to the risk profile of the property. For example, if the subject proeprty is located at a stronger location than the comparable property then the cap rate of the comparable is adjusted upwards to derive the cap rate for the subject property. Determining the magnitude of these adjustments is not easy, and they are left to the judgement of the valuer based on his experience of variation of cap rates acros properties in the local market. Ideally, such adjustments need to be estimated through econometric models, but this is rarely feasible due to the lack of sufficient data for estimating such models.
Note that if the analyst is using, for example, five comparables then the cap rate calculation is likely to derive 5 different figures for the subject property by appropriately adjusting the cap rates of each of the comparable transactions. The final cap rate to be applied to the property can be calculated as the simple average of the five estimates, or as a weighted average by applying different weights to each estimate from the different comparables based on the degree of similarity of each comparable to the subject, or the degree of the reliability of the comparable cap rate figure as perceived by the analyst.
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 cap rate 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 it is necessary to make some assumptions 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 rather than projections for next year. In many cases, even the former piece of information is not known and some data vendors may use in the cap rate formula 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”.
Valuation-Based Capitalization Rates
Valuation-based (as opposed to transaction-based) cap rates are estimated for properties that have not been transacted recently, and as a result a transaction price is not available. As the term implies, with no transaction price available, the 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
Valuation-based cap rates do not reflect market capitalization rates as accurately as transaction-based cap rates, given that the transactions used for the estimation of the latter are normal arm’s length market transactions and there are no distortions of transacted prices for any reason. An example of valuation-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 using these data provides estimates of valuation-based capitalization rates. However, notice that as 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. Furthermore, the appraised values reported for a given quarter, may represent the result of valuations carried out in previous quarters, as institutional investors do not appraise their properties every quarter. Given these data limitations, the cap rate reported by NCREIF is estimated using current NOI as opposed to next year’s NOI.
When using market cap rates provided by vendors investors need to have in mind that these vary 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.
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