Capitalization rates are a critical component when real estate investors compare different investment opportunities. Unfortunately, cap rates are often misunderstood and improperly derived, which can affect the accuracy of a property’s valuation.

Cap Rates in a Nutshell

A property’s capitalization rate represents its rate of return based on the expected income generated by the property. It is used to estimate the potential return on investment and to quantify the risk related to attaining that return.

The cap rate (CR) is calculated by dividing net operating income (NOI) (expected income after fixed and variable costs, not including debt costs) by the total market value of the property (FMV): CR = NOI / FMV

The Impact on Valuation

NOI, cap rate and property value are all interrelated, so that a property’s value can be determined using its NOI and applying a cap rate: FMV = NOI / CR. Application of a cap rate that is too high will result in underestimating a property’s value and vice versa.

Different approaches in determining the NOI of comparable properties will result in differences in selecting what cap rate to use when valuing a property. For example, if one party takes account of management company fees in computing the NOI, and another does not, they will arrive at different cap rates. Excluding the fees produces a higher cap rate, thereby reflecting the increased risk from the lack of professional management. The inclusion or exclusion of replacement reserves in the NOI calculation can likewise affect the cap rate of a comparable property.

Discrepancies can also arise if one party derives a cap rate using the historical income of comparable properties. Developing a cap rate using historical data — and then applying that cap rate to the subject property’s year-1 income projections — will overvalue the property because projected income is riskier than historical income. Instead, base the cap rate on the pro forma projections of the comparable properties, which will have risks similar to that of the year-1 projections of the property you are seeking to acquire.

Beyond the Numbers

There is no single approach for calculating cap rates. Income and expense projections are treated differently by different parties and for different purposes. With the cap rate having such a significant effect on a property’s value, it is vital that you select an appropriate cap rate for your valuation.

For more information on calculating capitalization rates, contact Bob Rifkin at 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.