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.
NOI = $100,000
Cap Rate = 10 percent
Value = $1 million
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.
Selecting 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.
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.