The document discusses capitalization (cap) rates, which are percentages used to value income-producing real estate. A cap rate is calculated by taking the next year's stabilized net operating income and dividing it by the property's purchase price. Lower cap rates indicate higher property values, while higher cap rates signal lower values. The document provides examples of how to calculate and use cap rates to determine property valuations based on net operating income. It also discusses factors that influence cap rates and where to find market cap rate data.

1. Real Estate Financial Modeling’s
Truly Understanding Cap Rates
Instruction by Bruce Kirsch
Principal, Real Estate Financial Modeling
Copyright © 2012 by Real Estate Financial Modeling, LLC. All Rights Reserved.
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2. Capitalization (Cap) Rates
• What is a real estate “Cap Rate”?
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• Short for Capitalization Rate
• A Cap Rate is a percentage (%) that
reflects the desirability of a particular
type of cash flow stream
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3. Capitalization (Cap) Rates
• Next Year’s “Stabilized” (flat, or growing
relatively smoothly) Adjusted Net Operating
Income/Purchase Price = Cap Rate %
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• An “8 Cap” is a Property with a Cap Rate of
8.00%, which is equivalent to a valuation
(Purchase Price) of 12.5x Next Year’s Stabilized
Adjusted Net Operating Income
>> Go To Excel tab: Sample Cash Flow Statement
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4. Net Operating Income vs. Adjusted NOI
Data Series
OPERATING INCOME Profile Total 2013 2014 2015 2016 2017
Gross Potential Rental Revenue $23,790,292 4,500,000 4,590,127 4,816,605 4,925,280 4,958,280
Vacancy ($365,404) 0 (45,901) (72,249) (98,506) (148,748)
Net Base Rental Revenue $23,424,887 4,500,000 4,544,226 4,744,356 4,826,774 4,809,531
Percentage Rents $355,869 93,305 66,210 66,926 64,003 65,425
Total Rental Income $23,780,756 4,593,305 4,610,436 4,811,282 4,890,777 4,874,956
Expense Reimbursements -1.15% -4.56% -1.02% -9.38%
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CAM Billings
Property Tax Billings
$2,098,620
$1,788,486
445,368
390,428
440,267
370,123
420,196
351,126
415,895
346,681
376,894
330,128
Ancillary Income $115,823 24,580 24,298 23,191 22,953 20,801
Gross Income $27,783,685 5,453,681 5,445,124 5,605,795 5,676,307 5,602,778
Credit Loss1 1.00% ($237,903) (45,000) (45,901) (48,166) (49,253) (49,583)
Total Operating Income $27,545,782 5,408,681 5,399,223 5,557,629 5,627,054 5,553,196
OPERATING EXPENSES
Reimbursable Expenses:
Common Area Maintenance ($2,412,257) (445,368) (463,183) (481,710) (500,978) (521,018)
Property Taxes ($2,114,684) (390,428) (406,045) (422,287) (439,178) (456,746)
Non-Reimbursable Expenses:
Insurance ($300,866) (55,548) (57,770) (60,081) (62,484) (64,983)
Utilities ($569,331) (105,114) (109,319) (113,691) (118,239) (122,969)
Management ($452,696) (83,580) (86,923) (90,400) (94,016) (97,777)
Total Operating Expenses ($5,849,834) (1,080,038) (1,123,240) (1,168,169) (1,214,896) (1,263,492)
NET OPERATING INCOME $21,695,948 4,328,643 4,275,983 4,389,460 4,412,158 4,289,704
CAPITAL & LEASING COSTS
Tenant Improvements ($311,299) (36,200) (57,629) (152,145) (46,696) (18,629)
Leasing Commissions ($205,810) (12,200) (41,722) (107,561) (25,567) (18,760)
Capital Expenditure Reserves ($653,806) (103,400) (323,565) (190,919) (24,947) (10,975)
ADJUSTED NOI $20,525,033 4,176,843 3,853,067 3,938,835 4,314,948 4,241,340
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5. Cap Rate Calculation
• Next Year’s “Stabilized” (flat, or growing relatively
smoothly) Adjusted Net Operating Income/Purchase
Price = Cap Rate %
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This Year Next Year
Net Operating Income $1,900,000 $2,000,000
Today's Purchase Price $25,000,000
$2,000,000
Cap Rate = = 8.00%
$25,000,000
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6. Cap Rate and Valuation Multiple Reciprocal Relationship
NOI
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Cap Rate Multiple
5.00% = 5/100 Reciprocal = 100/5, which = 20.0x
8.00% = 8/100 Reciprocal = 100/8, which = 12.5x
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7. Cap Rates Continuum
"High" "Low"
Cap Rates 12% 11% 10% 9% 8% 7% 6% 5% 4%
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"Compression" of Cap Rates
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8. Cap Rates and Equivalent Multiples
"High" "Low"
Cap Rates 12% 11% 10% 9% 8% 7% 6% 5% 4%
"Compression" of Cap Rates
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"Expansion" of Multiples
Multiples 8.3x 9.1x 10.0x 11.1x 12.5x 14.3x 16.7x 20.0x 25.0x
"Low" "High"
Purchase Price $16,667 $18,182 $20,000 $22,222 $25,000 $28,571 $33,333 $40,000 $50,000
on $2MM of NOI
($000s)
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9. Back Solving Using Cap Rates
Property Valuation
Net Operating Purchase Price Capitalization Valuation
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Income EDIT Rate Multiple
$2,000,000 $40,000,000 5.00% 20.0x
$2,000,000 $25,000,000 8.00% 12.5x
$2,000,000 $20,000,000 10.00% 10.0x
$1,250,000 $25,000,000 5.00% 20.0x
$2,000,000 $25,000,000 8.00% 12.5x
$2,500,000 $25,000,000 10.00% 10.0x
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10. Quoted Cap Rate Reconciliation
• Was it a 6 Cap or a 7 Cap?
• The Seller says they sold at a 6 Cap
CLICK The Buyer says they bought at a 7 Cap, meaning that the
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first year’s NOI/Purchase Price will yield them 7%
• Since the purchase price (denominator of the equation) is
what it is, the discrepancy in the math stems from the
numerator (NOI)
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11. Quoted Cap Rate Reconciliation
• Ask them nicely: How are you defining NOI?
• Is it Stabilized NOI? How do you define that?
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• Is it before or after Normalized Capex?
• What Normalized Capex did you assume?
• Is it before or after Normalized TIs?
• What Normalized TIs did you assume?
• Is it before or after Normalized Leasing Commissions?
• What Normalized LCs did you assume?
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12. Capitalization (Cap) Rate Composition
• Cap rates are driven by and based on market data
• The actual cap rate for a specific property is based on:
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• A base risk‐free rate (U.S. Treasury Bonds)
• The characteristics of the asset
• Availability and reliability of market data and
similarity of other assets for which market data is
available and reliable (occupancy, quality, age,
location, tenant mix and profile)
• Level of perceived risk associated with the asset
• How other likely buyers would evaluate the property
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13. Capitalization (Cap) Rate Composition
Risk-free rate 1.50% U.S. Treasury
Property occupancy level 1.00%
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Quality 1.00% Subjective
Age 1.00% Subjective
Location 1.00% Subjective
Tenant mix and credit 2.00% Subjective
Total Cap Rate 7.50%
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14. Capitalization (Cap) Rate Composition
Risk-free rate 1.50% U.S. Treasury
Property occupancy level 1.00%
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Quality 1.00% Subjective
Age 1.00% Subjective
Location 1.00% Subjective
Tenant mix and credit 2.00% Subjective
Total Cap Rate 7.50%
A 600 basis point (6%) Spread To Treasuries Is Estimated
>> Go To Excel tab: Cap Rate Composition & Calc’n
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15. Cap Rate Calculation – Alternate Approach
• The cap rate is in essence the weighted average of:
• the return to debt, and
CLICK the return to equity
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• NOI ends up paying both debt service and (on a residual
basis after debt service is paid) equity returns
>> Go To Excel tab: Cap Rate Composition & Calc’n
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16. Future Cap Rate Estimation
• Future anticipated risk‐free rate, plus a risk spread
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17. Cap Rate Data Sources – Where Sales Data Exists
• Real Capital Analytics
• Reis
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• Real Estate Alert
• Business journals (e.g., Washington Business Journal)
• Investment sales broker packages/research reports
• Costar/Loopnet
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