Capitalization rates are a critical component when real estate investors are comparing different investment opportunities. Unfortunately, cap rates are often misunderstood and improperly derived, which can affect the accuracy of a property 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’s used to estimate the potential return on an investment and quantify the risk related to actually attaining that return. The cap rate is calculated by dividing the expected income (after fixed and variable costs, not including debt costs), or net operating income (NOI), by the total value of the property.
The impact on valuation
The interrelationship of NOI, cap rate and property value means that a property’s value can be determined using the NOI and the cap rate — property value equals the NOI divided by the cap rate. A higher cap rate will therefore result in a lower property value, NOI being equal. Obviously, then, application of a cap rate that is too high to the subject property will result in an underestimate of the property’s value, and vice versa.
Disputes over the proper cap rate to use when valuing a property can stem from different approaches to developing a cap rate from comparable properties, particularly when calculating the properties’ NOI. For example, if one party takes account of management company fees in computing the NOI, and the other doesn’t, they will arrive at different cap rates. Excluding the fees produces a higher rate that reflects the increased risk from the lack of professional management. The inclusion or exclusion of replacement reserves in the NOI calculation can likewise affect a comparable property’s cap rate.
Discrepancies can also arise if one party derives the cap rate from data on comparable properties using historical income. Developing a cap rate from historical data and then applying it to the subject property’s year-1 income projections will overvalue the property because projected income is riskier than historical income. Instead, the cap rate should be based on comparable properties’ pro forma projections, which will have risk similar to that of the year-1 projections.
Beyond the numbers
No single approach for calculating cap rates exists — 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’s vital that you ensure an appropriate cap rate is employed for your valuation.