What is a Cap Rate?

What is a Cap Rate?

Simply expressed, a cap rate (R) is equal to income (I) divided by value (V). The relationship can be expressed in any of the following forms:

Formula 1: I ÷ V = R

Formula 2: I ÷ R = V

Formula 3: I = RV

Appraisers have three approaches to value they can utilize when valuing a property: the cost approach, the sales comparison approach, and the income approach. We will ignore the cost approach and sales comparison approach in this article, as cap rates are most relevant to the income approach.

Within the income approach, there are two options to produce a value indication: direct capitalization and yield capitalization. Yield capitalization is often reserved for complex assignments. Direct capitalization is the more common method of generating a value indication via the income approach.

In direct capitalization, appraisers first use formula 1 ( I ÷ V = R ) to extract cap rates from comparable sales within the market. Income (I) is equal to the net operating income (NOI) of the comparable sale, value (V) is equal to the sale price of the comparable sale, and the resulting rate (R) represents the cap rate for the sale. Take the following sales for example:

After researching each comparable sale, the appraiser determines what cap rate is appropriate for the subject property. The determination is based on consideration of the risk associated with the projected NOI of each comparable sale, as well as the risk associated with the subject’s projected NOI.

Once the appraiser selects an appropriate cap rate for the subject, formula 2 ( I ÷ R = V ) is utilized to produce a value indication within the income approach. Here, income (I) is equal to the subject’s NOI, rate (R) is equal to the selected cap rate for the subject, and value (V) is equal to the value indication for the subject via the direct capitalization method of the income approach.

Let’s say the subject property is generating $105,000 in NOI, and the appraiser determined a cap rate of 5.00% is appropriate for the subject. Then, the subject’s value indication via the direct capitalization method would be calculated as follows:

So far, this article has explained what cap rates are, and how they are utilized by appraisers. It is just as important to know what cap rates are not, and how they can be misused by market participants, including appraisers.

Cap Rates in the Market

Use caution when considering cap rates utilized in the market, especially when looking at marketing materials for a property listed for sale. While the formula for calculating a cap rate is standardized, the income (I) portion of the formula is often calculated in a variety of ways by market participants, and how it is calculated impacts the resulting cap rate indication. Common things I see that may lead to a misleading cap rate for a sale include:

1) Overstating income

2) Omitting a deduction for vacancy and collection loss

3) Omitting or understating expenses typical in the market

Another way cap rates are used in a misleading way in the market is when they are referenced as being the yield rate for an investment. Earlier in this article, I noted there are two methods of producing a value indication via the income approach: direct capitalization (which uses a cap rate) and yield capitalization. Yield capitalization considers all projected cash flows throughout the projected holding period of an investment, including the sale of the property at the end of the projected holding period. Conversely, direct capitalization considers only the projected income at one point in time, typically one year’s NOI as of the effective date of value.

Still have questions about cap rates or anything else appraisal related?

Call Aaron Soave, MAI directly at (562) 337-9246, or email him at: asoave@aptvaluation.com