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Posted by Stan Tish, MAI on Friday, September 16, 2011

The Proper Extraction and Use of Cap Rates in Real Estate Valuation


Beware! Veteran appraiser and Opine Expert Stan Tish offers a concise explanation of the proper use of “Cap Rates” in valuing income properties. It is a must-read for those who use Cap Rates as a rule of thumb, as it clearly illustrates how failing to verify underlying income data and make appropriate adjustments can lead to a misuse of the income capitalization concept. These mistakes can result in wildly inaccurate valuations, uninformed investment decisions – and potential legal liability. The takeaway: Do not value a property applying a presumed Cap Rate to an unexamined income stream. Cap Rates are properly applied only to a Net Operating Income number that assumes stabilized occupancy and market rents; and any costs required to achieve that operating status are adjustments to the capitalized value thus arrived.

The Proper Extraction and Use of Cap Rates in Real Estate Valuation

The term “Cap Rate,” shorthand for the income capitalization approach to real estate valuation, is a blithely used rule of thumb for valuing income properties. Unfortunately, however, I have seen both investors and advisors take this shortcut right off the road. For as much as it is time-honoured method of valuing income properties, it requires rigorous discipline in its application. And misuse results in wildly inaccurate valuations, uninformed investment decisions, and potential legal liability.

The income capitalization approach to value is based upon the principle of anticipation, i.e., that value is created by the expectation of benefits to be derived in the future. “Value is most clearly defined as the present worth of all rights to future benefits arising from ownership.”1 The future benefits of income-producing investment property are typically monetary: periodic income and a resale value or reversion.

Income capitalization measures future benefits by converting them into a lump-sum present value or capital sum (hence the term “capitalization”), which typically provides a fair indication of market value. Valuation methodology distinguishes two forms of income capitalization: yield capitalization, which discounts a series of cash flows to present worth, and direct capitalization. Direct capitalization is described as:

A method used to convert an estimate of a single year's income expectancy into an indication of value in one direct step, either by dividing the income estimate by an appropriate rate or by multiplying the income estimate by an appropriate factor.2

As the product of direct capitalization represents the present worth of all future benefits, it is often referred to as capitalization in perpetuity. In order for the analysis to reflect market value:

The income from the property must reflect its highest and best use. o The periodic income is estimated by evaluating market rental rates and the operational characteristics of the property. Though income may vary year to year, it is stabilized based upon current and anticipated market conditions and the expected performance of the property. o An appropriate capitalization rate is used which is based upon an analysis of recent sales transactions (if available); is commensurate with the risks inherent in the production of the income; and reflects the current expectations of buyers and sellers.

Applying the Overall Rate

In direct capitalization a single year’s net operating income (NOI) – typically the income anticipated for the first year after the date of value – is divided by the overall rate of capitalization. As a single year’s income is being converted into a capital sum that is the present worth of all future benefits, the income to be capitalized must be net operating income, a stabilized income based upon market rent net of stabilized operating expenses.

If you capitalize income from a below-market contract rent, you are capitalizing a revenue loss in perpetuity that persists only until the end of the lease term. The situation is similar with above-market rents: you would be capitalizing revenue in perpetuity that is only temporary.

The overall rate with which NOI is capitalized is the rate for the property overall, i.e., for the total property – not just for the building, or the land, or the mortgage component, or the equity, or the leased fee, or the leasehold – but the total property overall. It is the rate, essentially, for the fee simple interest. Capitalization of NOI is the basis of direct capitalization, even when the property is not at stabilized occupancy, not leased at market rates, or when the property interest being appraised is the leased fee.

For illustration, let’s consider a few examples based upon a 50,000 s.f. building that will produce NOI of $20.00/s.f. or $1 million at stabilized occupancy and market rent (i.e., fully leased at market rent less stabilized expenses). We have selected an overall rate of 10.0% based upon the range of capitalization rates extracted from sales data.

Example 1- Stabilized Occupancy at Market Rent (Correct Methodology)

Net Operating Income: 50,000 s.f. @ $20.00 = $1,000,000 • Overall Rate: 10% • Indicated Value: $10,000,000

The value indicated by direct capitalization is $10 million. Now let’s suppose that contract rent is below market, and the income net of expenses generated under the lease is only $15.00 (but that in three years the lease requires an adjustment to market rent). The sale should be analyzed in the same manner as subject, i.e., based upon a pro forma or stabilized operating statement in which NOI from market rent is estimated and capitalized. A common error is to forego the estimation of NOI and capitalize the actual income from contract rents. In Example 2A, this procedure would indicate a value of $7,500,000.

Example 2A - Capitalizing Income From a Below-Market Contract Rent (Incorrect Methodology)

Contract Net Income: 50,000 s.f. @ $15.00 = $ 750,000 • Overall Rate: 10.0% • Indicated Value: $7,500,000

The methodology is improper and fallacious: the revenue loss from below-market rent lasts for three years but is being capitalized in perpetuity, vastly overstating the adverse impact on value. The correct procedure is to capitalize NOI from market rent and deduct the present worth of the three-year revenue loss from the capital value, as follows:

Example 2B - Below-Market Rent (Correct Methodology)

Net Operating Income: 50,000 s.f. @ $20.00 = $1,000,000 • Overall Rate: 10.0% • Indicated Value, Stabilized Occupancy & Market Rent: $10,000,000 • Less: Revenue Loss from Below-Market Rent, 50,000 s.f. @ $5.00, 3 years @ 12.0% = (595,336) • Indicated Value, As-Is (Rounded): $9,400,000

As you can see by comparing the methodology correctly (2B) and incorrectly (2A) employed, capitalizing the income from below-market rents understates market value by $1.9 million in this particular example (which includes neither a very large building nor a very high rent differential from contract to market).

If the lease were expected to turn over in three years, we would also have to deduct a leasing commission and perhaps also a refurbishing cost and a revenue loss from vacancy at turnover, as we shall see in an ensuing example.

For the next case, let’s suppose that 20% or 10,000 s.f. of the building is vacant. If you capitalize only the income being produced by the current occupancy, you will again drastically overstate the financial impact of the vacancy.

Example 3A - Capitalizing the Current Occupancy (Incorrect Methodology)

Contract Net Income: 40,000 s.f. @ $20.00 = $ 800,000 • Overall Rate 10.0% • Indicated Value: $8,000,000

The methodology is incorrect because it foresees no income from the currently vacant space in perpetuity. It is tantamount to saying the vacant rentable area no longer exists. What would the value be by this methodology if the building were completely vacant?

Let’s say that our market research has determined that the lease-up time for 10,000 s.f. at market rent is one year, that the requisite leasing commission is equivalent to 25% of the first year’s net operating income, and that the space will have to be refurbished at a cost of $5.00/s.f. to achieve a market rate of rent. The correct methodology is analogous to Example 2B above:

Example 3B Partial Vacancy (Correct Methodology)

Net Operating Income 50,000 s.f. @ $20.00 = $1,000,000 Overall Rate: 10.0% Indicated Value, Stabilized Occupancy & Market Rent: $10,000,000 Less: Revenue Loss from Vacancy 10,000 s.f. @ $20.00, 1 year = (200,000) Less: Leasing Commission $200,000 X 25.0% = (50,000) Less: Refurbishing Cost 10,000 s.f. @ $5.00 = (50,000) Indicated Value, As-Is (Rounded) = $9,700,000

Comparing the results of 3A and 3B, we can see that even in this very limited example, the incorrect methodology understates market value by $1.7 million. If the building were completely vacant, the methodology would be the same; only the numbers would change accordingly. A case can be made that the prospective buyer is entitled to an entrepreneurial reward or profit for undertaking the effort to achieve stabilized occupancy at market rent but that, as they say, is another story.

In the case of above-market rents the procedure is still to apply the overall rate to NOI from market rent; if you capitalize the total rent you are attributing value to the property in perpetuity that lasts only as long as the remaining term of the lease. The present worth of the above-market rent component, discounted at a risk rate, is added to the capitalized value. If 10,000 s.f. is leased for an additional two years at a rent producing $22.00/s.f. in net income, the procedure is as follows:

Example 4Above-Market Rent(Correct Methodology)

Net Operating Income 50,000 s.f. @ $20.00 = $1,000,000 • Overall Rate: 10.0% • Indicated Value, Stabilized Occupancy & Market Rent: $10,000,000 • Plus: Revenue from Above-Market Rent, 10,000 s.f. @ $2.00, 2 years @ 13.5% = 39,335 • Indicated Value, As-Is (Rounded) = $10,040,000

For the last example, let’s put it all together: for the same 50,000 s.f. building with NOI of $20.00/s.f. at market rent, we have a vacancy of 20% or 10,000 s.f. with a one-year lease-up, leasing commission, and refurbishing cost; 20% or 10,000 s.f. at below-market rent for three years producing $15.00/s.f. net income, with turnover expected at lease expiration; and 10,000 s.f. at above-market rent producing an additional $2.00/s.f. net income for two years.

The correct methodology proceeds from capitalization of NOI and the value of the fee simple interest through adjustments for the costs to achieve stabilized occupancy at market rent. Income from contract rents are not capitalized (unless they are at market), and vacant space is capitalized based upon market rent.

Example 5 Partial Vacancy With Below-Market & Above-Market Rents (Correct Methodology)

Net Operating Income 50,000 s.f. @ $20.00 = $1,000,000 • Overall Rate: 10.0% • Indicated Value, Stabilized Occupancy & Market Rent: $10,000,000 • Less: Revenue Loss from Vacancy,10,000 s.f. @ $20.00, 1 year = (200,000) • Less: Revenue Loss from Below-Market Rent 10,000 s.f. @ $5.00, 3 years @ 12.0% = (147,049) • Less: Leasing Commission 20,000 s.f. @ $20.00 X 25.0% = (100,000) • Less: Refurbishing Cost 20,000 s.f. @ $5.00 = (100,000) • Plus: Revenue from Above-Market Rent, 10,000 s.f. @ $2.00, 2 years @ 13.5% = 39,335 • Indicated Value, As-Is (Rounded) = $9,500,000

If you want to use a sharper pencil you could discount the revenue loss from vacancy, leasing commissions, and refurbishing cost to present value as they will not be incurred for more than a year after the value date. The fundamental concept is that the overall rate is properly applied only to NOI at stabilized occupancy and market rent; any costs required to achieve that operating status then become an adjustment to the capitalized value. Although there are analogous procedures to value certain property components, e.g., dividing the equity dividend by the equity dividend rate, there is no “leased fee capitalization rate” that can be applied to properties that are not at stabilized occupancy or at market levels of rent.

Extracting the Overall Rate

Derivation of overall rates from sales is the preferred technique when there are sufficient data on sales of competitive properties. NOI for each sale property is divided by its sale price; the resulting ratio expressed as a percentage is the overall rate.

Example 6 Calculating the Overall Rate (Correct Methodology)

Net Operating Income: $ 838,351 • Sale Price: $ 9,165,000 • Overall Rate: 9.15%

As the overall rate is applied to NOI at stabilized occupancy and market rent, it should be extracted from sales on the same basis. Income and expenses for the sale properties are analyzed in the same manner as subject’s in order to estimate NOI. If either NOI or an overall rate is reported by a participant in the sales transaction, in contrast to being the product of an analysis, it is incumbent upon the appraiser to ascertain whether those figures reflect a reserve or replacement allowance, old or new real property taxes, current or projected rents, or any other element that may differ from the analysis of subject.

The ideal situation is a sale that was only recently leased at market rent; but this rarely occurs. In most cases, sale properties exhibit vacancies, below-market rents, above-market rents, deferred maintenance, a need for refurbishing, etc. Regardless, the sale is analyzed based upon its capacity to produce NOI, and the sale price is adjusted by the costs required to achieve that operating performance. Example 7 illustrates the extraction of an overall rate from a sale, based upon the same conditions and assumptions as in Example 5 above.

Example 7- Extracting the Overall Rate (Correct Methodology)

Potential Gross Income (PGI) 50,000 s.f. @ $25.00 = $1,250,000 • Less: Vacancy & Collection Loss (5.0% PGI): (62,500) • Effective Gross Income (EGI): $1,187,500 • Less: Management (3.0% EGI): (35,625) • Less: Reserve (2.0% PGI): (25,000) • Total Operating Expenses: (60,625) • Net Operating Income: $1,126,875 • Sale Price: $10,500,000 • Revenue Loss from Vacancy, 10,000 s.f. @ $20.00, 1 year = 200,000 • Revenue Loss from below-Market Rent, 10,000 s.f. @ $5.00, 3 years @ 12.0% = 147,049 • Leasing Commission, 20,000 s.f. @ $20.00 X 25.0% = 100,000 • Refurbishing Cost, 20,000 s.f. @ $5.00 = 100,000 • Revenue from Above-Market Rent, 10,000 s.f. @ $2.00,2 years @ 13.5% = (39,335) • Total Cost: $11,007,714 • Overall Rate: 10.24%

Sale properties typically vary widely in the relation of contract to market rent, remaining periods to lease turnover, refurbishing costs, rent concessions, vacancies, and other factors. However, income capitalization relies upon NOI – a stabilized income derived from market rent net of stabilized expenses. The calculation and use of rates either extracted from, or applied to, income other than NOI is an inaccurate and unreliable parody of direct capitalization.

  1. L.W. Ellwood, M.A.I., “All Rights to Future Benefits,” in Readings in the Income Approach to Real Property Valuation, Vol. 1, American Institute of Real Estate Appraisers of the National Association of Realtors (1977), p. 19.
  2. Appraisal Ins

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