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Understanding Capitalization Rates or Cap Rates


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This document provides an in-depth look of the capitalization rate, or cap rate, metric commonly used in real estate.

Published in: Real Estate
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Understanding Capitalization Rates or Cap Rates

  1. 1. A primer on this widely used, but seldom understood, real estate metric UNDERSTANDING CAPITALIZATION RATES OR CAP RATES
  2. 2. WHAT IS A CAP RATE ? Ploutus Advisors, LLC 1 ¡  Rate of interest or return that is considered as “reasonable” return on investment ¡  Rate used to derive an estimate of property value based on net income ¡  Preliminary test for reasonableness of purchase price of property ¡  Inverse of a multiple ¡  Used in Direct Capitalization as follows: R = NOI1 ÷ V where, R is Capitalization Rate or Cap Rate NOI1 is Net Operating Income for the first year of holding period V is Value of property
  3. 3. CAP RATE VS. DISCOUNT RATE Ploutus Advisors, LLC 2 ¡ Cap Rate is related to a Discount Rate §  Discount rate, investment yield, or internal rate of return is the risk adjusted required return for an investment when compared with returns earned on competing investments ¡ Relationship is as follows: R = r − g OR r = R + g where, R is Capitalization Rate or Cap Rate r is Discount Rate g is Annual Growth in Income Cap Rates will equal Yield Rates only when the expected annual growth in income is Zero
  4. 4. RISK AND CAP RATES Ploutus Advisors, LLC 3 HIGH Property Value Low Cap Rate Low Risk LOW Property Value High Cap Rate High Risk Return on Investment is inversely correlated to probability of Return of Investment
  5. 5. METHODS FOR ESTIMATING A CAP RATE Ploutus Advisors, LLC 4 Sales Comparable Approach Gettel Approach Band of Investment Approach Akerson Approach Ellwood Approach
  6. 6. SALES COMPARABLE APPROACH Ploutus Advisors, LLC 5 Cap Rate: Calculated as NOI ÷ Price 1 Subject Cap Rate: Comparable properties must be carefully analyzed before choosing the appropriate Cap Rate so as to accurately reflect overall similarity Subject Sales Comparables Property 1 Property 2 Property 3 Price $10,032,103 $10,000,000 $9,750,000 $10,250,000 NOI $625,000 $625,000 $600,000 $645,000 Cap Rate 6.23% 1 6.25% 6.15% 6.29% Use only when sufficient comparable sales data is available
  7. 7. RONALD GETTEL APPROACH Ploutus Advisors, LLC 6 Takes into account lender’s perspective Loan-to-Value 70.00% x Debt Service Coverage Ratio 1.25x x Loan Constant (Debt Service ÷ Loan Amount) 7.92% Loan Annual Interest Rate 5.00% Amortization in Years 20 Cap Rate 6.93%
  8. 8. BAND OF INVESTMENT APPROACH Ploutus Advisors, LLC 7 Equity Dividend Rate (EDR): Current Before-Tax Cash Flow ÷ Invested Equity 1 EDR: Also referred to as current return on equity (ROE) or cash return on invested equity for equity investor Takes into account investment criteria of debt and equity Item Rate Weight Contribution to Cap Rate Equity Equity Dividend Rate Equity-to-Value 8.00% 30.00% 2.40% Mortgage Loan Constant Loan-to-Value + 7.92% 70.00% 5.54% Loan Annual Interest Rate 5.00% Amortization in Years 20 Loan Constant = Debt Service ÷ Loan Amount 7.92% Cap Rate 7.94%
  9. 9. CHARLES AKERSON APPROACH Ploutus Advisors, LLC 8 Takesintoaccountinvestmentcriteriaof debtandequityandaccountsforloan repaymentandchangeinpropertyvalue Item Rate Weight Contribution to Cap Rate Equity Equity Dividend Rate Equity-to-Value 8.00% 30.00% 2.40% Mortgage Loan Constant Loan-to-Value + 7.92% 70.00% 5.54% Loan Annual Interest Rate 5.00% Amortization Period in Years 20 Loan Constant 7.92% Cap Rate - Band of Investment Approach 7.94% (a) Adjustment 1: Equity Build-Up or Loan Paid-Off 1.83% Loan-to-Value 70.00% Holding Period in Years 10 + Sinking Fund Factor - SFF 6.90% Loan Paid-Off Over Holding Period 37.78% Adjustment 2: Change in Property Value 0.69% Appreciation Over Period 10.00% SFF 6.90% Total Adjustment 2.52% (b) Cap Rate 5.43% (a) - (b)
  10. 10. L. W. ELLWOOD APPROACH Ploutus Advisors, LLC 9 Item Key General Factor Used K J Equity Dividend Rate r 8.00% Loan-to-Value mr 70.00% Amortization Period in Years t 20 Loan Annual Interest Rate i 5.00% Loan Constant mc = -PMT(i,t) 7.92% Holding Period in Years n 10 Sinking Fund Factor SFF = r/((1+r)^n-1) 0.0690 % Paid Off Over Holding Period P = (mc-i)/(-PMT(i,n)-i) 37.78% PV Factor Ordinary Level Annuity An = (1-(1+r)^(-n))/r 6.710 FV Factor Sn = (1+r)^n 2.159 Change in Value Over Holding Period Dv 5.00% Constant Change in Income Per Year g 2.00% Change in Income Over Holding Period Di 5.00% K Factor K = (1-((1+g)^n/Sn))/((r-g)*An) 1.081 J Factor J = SFF*(n/(1-(1/(1+r)^n))-(1/r)) 0.423 Cap Rate - K Factor Cap (K) = (r-mr*(r+P*SFF-mc)-Dv*SFF)/K 5.34%   Cap Rate - J Factor Cap (J) = (r-mr*(r+P*SFF-mc)-Dv*SFF)/(1+Di*J) 5.65% Ellwood formula was later restated as Akerson’s approach KFactor-Factorusedtoconvertstream ofincomechangingatconstantratioor compoundingrateintolevelequivalent payments JFactor-Factorusedtoconvertvariable streamofincomeintolevelequivalent payments
  11. 11. CONTACT US Ploutus Advisors, LLC 10 Disclaimer: The information contained herein may be subject to errors, omissions, changes in assumptions and, other factors. We do not provide any guarantees, express or implied, and/or make any representations as to the accuracy of the assumptions used and/or other information contained herein. All information contained herein is only for purposes of illustration, and should be independently verified by the user. The analysis represents our interpretation and is NOT intended to replace information received from tax and/or accounting professionals. The user is advised to conduct their own due diligence and consult with their advisors prior to making any decision. For real estate consulting and advisory, please contact: Mr. Adnan Tapia Email: Tel: +1.424.274.3561 Ploutus Advisors, LLC 1875 Century Park East, Suite 700 Century City CA 90067 Adnan is a Principal at Ploutus Advisors, LLC; a boutique real estate investment and advisory firm based in Los Angeles, California. Over a period of 18 years, Adnan has worked on 16+ million square feet or US$2.5 billion worth of US and India focused real estate transactions across several product types (office, industrial, retail, residential, hospitality, mixed-use, land) and life cycles in areas such as real estate private equity, financial consulting, acquisitions and development. Adnan graduated with a MBA in Banking and Finance from Case Western Reserve University, Ohio, and was nominated to The Honor Society of Beta Gamma Sigma. He also holds a Master in Engineering from Cornell University, New York, and Bachelor in Civil Engineering from University of Pune, India. In addition, he holds a California Real Estate Broker’s license and is a member of ULI, NAIOP and the Cornell Real Estate Council.