Options for Calculating an Overall Capitalization Rate

As a real estate owner or investor, you want to know the value of your commercial property.

Appraisers commonly estimate market value using the direct-capitalization approach, which divides net operating income by an overall capitalization rate.

Value = Net Operating Income / Overall Capitalization Rate

The overall capitalization rate (cap rate) is the factor that has the biggest impact on the value estimate. Consider the following examples.

Example 1:

NOI = $100,000

Cap Rate = 10 percent

Value = $1 million

Example 2:

NOI = $100,000

Cap Rate = 12 percent

Value = $833,333

As illustrated above, a two-percentage point difference in the cap rate significantly affects the market value estimate, so appraisers must proceed with great diligence in determining the overall cap rate on commercial property.

capitalization rateSelecting A Cap Rate

The appraiser will take into consideration a variety of factors, including the availability and reliability of market data and perceived risk associated with the property, in choosing one (or more) methods for determining a cap rate. Following are a few examples.

What the Market Will Bear

Real examples always carry more weight, and a cap rate derived from a sale of actual property is more likely to convince investors and underwriters. The formula for a market-extracted rate is:

Cap rate = Property NOI / Sale price

However, this rate will only hold water if the sale property is similar to the appraised property. Occupancy, age, location and quality of the property are all characteristics an appraiser will consider when comparing properties.

Constructed Rates

In the absence of comparable market data, an appraiser has several options for constructing an overall cap rate.

  • Band of investment method bases the cap rate on a composite of mortgage and equity funds. The appraiser will gather market data on the proportion of debt to equity in typical deals, as well as survey data regarding mortgage interest and equity return rates.
  • Debt coverage ratio method takes the bank’s perspective. The appraiser multiplies debt coverage ratio by loan-to-value ratio by the mortgage constant.
  • Yield capitalization is based on a rate of return, and it anticipates changes in income and value over a period of time.

Each of these methods relies on the accuracy of the underlying data and the appraiser’s professional judgment. Appraisers often use more than one method to determine a cap rate; ideally, the rates derived from each of the methods will vary only slightly.

Considering an appraisal? Our real estate professionals can help you derive a reasonable estimated value on your commercial property. Contact us or call 716.847.2651.