When arranging a loan or investing in real estate , understanding the use of capitalization approach (“ Cap Rates ”) is critical to the decisionmaking . This subject is important to commercial realtors , lenders , developers , and investors .
Definition of Capitalization Rate ( Cap Rate )
Cap Rates represent the ratio of Net Operating Income (“ NOI ”) to the property asset value ( NOI / Value = Cap Rate ). The income capitalization approach does not consider whether the property is free and clear with no debt service . NOI is simply gross rents , less a vacancy allowance , less operating expenses . If you have similar properties with similar characteristics in a similar geographical location that have recently sold in arm ’ s length cash transactions , you can calculate the comparison cap rates . Also , cap rates may vary , even in the same geographic location , depending upon the multiple types of properties . Examples are , Class A vs Class C office , industrial , apartments , new modern styles with amenities vs older dated properties . Additionally , the strength of the tenancy from national credit tenants with long term leases , vs a mom and pop ' s month to month tenancy would result in a different cap rate . Most likely the mom and pop tenancy would reflect a higher cap rate . An exception would be where the national credit tenant locks a lease / rental rate that does not increase as the market dictates or anticipates , reflecting what is referred to as below market rent . The mom and pop , on the other hand , could be converted to a market lease relatively quickly , by either acquiring a new tenant or by renegotiating the lease with a higher rent .
Market rents should be used rather than actual rents . In most cases , actual rents are lower . When there is a lease up period , such as with new construction of an incomeproducing property , future cash flows need to be estimated to the point of income stabilization , then the future stabilized income is discounted , utilizing an estimate of a capitalization rate , and a discount rate . Work with a good appraiser on this .
Once the market Cap Rate has been determined , you can apply it to the NOI and cap rate analysis of the property under consideration to indicate the probable market value . At this point , I want to credit competent commercial appraisers , who can assist us to find the correct Cap Rate . I would not try to do it myself , without the assistance of an appraiser with local experience .
At this point , I want to credit competent commercial appraisers , who can assist us to find the correct Cap Rate . I would not try to do it myself , without the assistance of an appraiser with local experience .
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