Stated one more time : Capitalization Rate represents the annual Net Operating Income ( NOI ) divided by the cap rate to derive the property asset value ( NOI / Cap Rate = Value ).
Why do we use Capitalization Rates ?
The capitalization approach is a “ comparative method ” of valuing property with similar properties , similar income streams , in similar geographic locations , and similar risks that will yield a comparable rateofreturn . Once the value is established , the comparative method can calculate the loantovalue to determine if property value falls within the lender ’ s loan underwriting guidelines .
Cap Rates are only one metric . Since the capitalization approach is calculated as if the property is debtfree the value will be the same whether the property has leveraged debt or is debtfree . It represents a market snapshot at the investment time and does not consider loan debt service or financing costs .
If an investor finances his acquisition , as most people do , further analysis such as cashoncash return will be helpful . Sophisticated loan underwriters and investors may also calculate an Internal Rate of Return . These calculations assist in establishing that the property is incomeproducing and a worthwhile investment .
A licensed commercial appraiser may perform a rent survey to determine market rents for a property type in a geographic area . Market rents may or may not be the same as actual rents ( contract rents ). There are many instances where the existing rents are above or belowmarket rents . A tenant with a longterm lease may have locked in lower rents sometime in the past .
I once underwrote a loan transaction on an industrial building near San Francisco that was about 100 years old . The property has a longterm lease of 18 cents per square foot , while the current market was $ 1.75 a square foot . Since current market rents were much higher , the valuation metric used was based upon the lockedin lower rental rate .
A property owner may own the property in one title method such as The Archie Bunker Corporation and occupy all or a portion of the building in different title method such as Archie Bunker Limited Liability Company . He may charge above or belowmarket rents to himself for tax purposes . Actual rents may also be higher than the market . In this case , the appraiser would use market rents rather than actual rents to determine the Cap Rate .
There are other instances where a conventional market Cap Rate analysis is inappropriate . The alternative method is a discounted cash flow analysis such as original groundup construction . The building cost and the cash flow from a leaseup need to be projected over a reasonable time to the point of stabilized occupancy . This is done by a competent appraiser who can construct a model estimating a future projected cash flow and using net present value discount formulas to estimate the capitalization rate . The result may differ from the market comparison method .
Suppose you have income properties with similar characteristics in a geographically close location sold in arm ’ s length cash transactions , and the income stream data is available . In that case , there are webbased databases that track comparison capitalization rates
( Cap Rates .)
Market rents are the amount of rent that can be expected for a property , compared to similar properties in the same geographic areas . Contract rent or actual current rent is what the same units are being rented for today . Many lenders will request a rental survey from an appraiser as an addon task to the requested appraisal job .
There is an essential difference between market rents and current actual ( contract ) rents in the Cap Rate valuation process . Compare two different buildings , both identical , but the first property is wellkept and rented at a market rate , and a second building that has deferred maintenance . The property with deferred maintenance is rented for undermarket rates by under 30 %. In both cases , a lender and the appraiser will use market rents to determine the ( NOI ). The assumption about the second building is that a new owner will upgrade the building and adjust the rents upward to a market rate . The value of the second building would be adjusted downward or discounted to offset the cost to cure ( cost to upgrade the building ).
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