Lesson 6
Capitalization Rate
Theory
The Income Approach is often the most
important method of analysis for determining value of income properties.
By definition, the two things from which value is determined using the
Income approach are Net Operating Income (NOI) and Capitalization Rate (Cap
Rate) because Value = NOI/Cap Rate. Accordingly, understanding
capitalization rates and knowing how to determine what rate to use for a
particular property is absolutely necessary to determining value by the
Income approach.
The cap rate is usually significantly greater
than the interest rate that an investor might accept for a safe passive
investment such as a Certificate of Deposit. In general, the cap rate
for a particular investment can be defined as the rate that investors expect
from that particular investment taking into account the risk, liquidity, and
management burden. In other words,
Safe Rate (minimum risk 
e.g., CD) S %
Add for additional risk
R
Add for nonliquidity
N
Add for management burden
M

Rate applicable to investment
Total %
Thus, we see why the rate used in
valuation of income property will be in excess of the safe rate.
Although the above provides illustration, it is not usually a valid way of
determining cap rates because the additive terms are not themselves usually
calculable. We might also subtract a rate based on the tax benefits
derived from the investment, but this would introduce an even more complex
variable due to the extreme variability of tax brackets. Even though
the above calculation cannot normally be used in the real world, it does
tell us that we should expect to use a higher cap rate for properties that
are extremely management intensive or in a questionable location and
that we should expect the cap rate to come down as the safe rate decreases.
There are a couple of ways to determine the
cap rate that you should use for your analysis. If you know a good
appraiser well enough, you can ask him what the current rate is for the
specific type of property under consideration. The advantage of this
way is that it is very easy. The disadvantage is that a
particular appraiser may not have available the correct cap rate for the
particular type of property. For example, if an appraiser has worked
on nothing except large regional shopping centers for the past year, he may
have less idea than you regarding what the current proper rate should be for
a 10unit apartment building in the suburbs. Similarly, your real
estate agent will probably have an opinion as to the correct cap rate.
However, again, unless he can back up his opinion with some analysis of
current market data, you must resist going the easy route. Keep in
mind that calculated value will be directly inversely related to the cap
rate used. For example, using a cap rate that is low by 10 percent
will give a value this is high by 11 percent  $22,000 high on a $200,000
property.
The bottom line is that you should know how
to determine the proper rate on your own and spend the necessary time to do
so. Even for small properties, using a low cap rate can cost thousands
of dollars. For larger properties, a lowcaprate error can amount to
many tens of thousands of dollars. Thus, performing the necessary
research and analysis can easily earn you hundreds of dollars per hour for
your efforts.
Cap rates can be derived by several theories,
including the Band of Investment, Direct Comparison, and Comparison of
Quality Attributes theories. For real estate investment, the most
commonly used and simplest method of determining the current capitalization
rate is by analyzing recent sales of similar properties  the Direct
Comparison method. For this we will need to know both the sale
price and the NOI for each comparable property. In the real world,
determining the NOI of comparable properties can be difficult because the
necessary data may not be easily available. Because of the difficulty
in obtaining the necessary information for comparables, it is recommended
that you include as many comparables as possible in your analysis so as to
average out the errors resulting from inaccurate data.
For our example in this lesson, we will
assume that you have a real estate agent who obtained the data for you, that
your friendly neighbor is a certified appraiser, or that you managed to
gather the information yourself and then calculated the NOI for each
property. We will not actually calculate the NOIs for the comparables.
We will be doing a detailed analysis of NOI for our subject property in the
next lesson and determining the NOIs for the comparable of this lesson would
be done exactly the same way.
Example
For our example we assume that the subject
property is the same 4plex that we used for our Reserve Account analysis of
Lesson 5 and that we have gathered the following information about four
recent sales.
While we could utilize income, vacancy,
and expense numbers to calculate NOI for each comparable, we will be doing
that when we use the Income Approach analysis in Lesson 7, so we will simply
list the NOI for each here.
Property 
Subject 
Comp
1 
Comp
2 
Comp
3 
Comp
4 
Property Type 
4plex 
4plex 
4plex 
4plex 
3plex 
Gross Square
Feet 
3480 
3400 
3885 
2650 
2800 
Unit Mix
(# times bdrm/bth) 
2 X
2/1
2 X 1/1 
2 X
2/1
2 X 1/1 
4 X
2/2 
4 X
1/1 
3 X
2/2 
Age (years) 
15 
22 
10 
27 
13 
Total Bedrooms 
6 
6 
8 
4 
6 
Total Baths 
4 
4 
8 
4 
4 
Distance from
Subject 

2
miles 
1/2
mile 
1
mile 
1
block 
Time since sale 

3
mo 
2
mo 
4
mo 
1
mo 
Sale Price 

$177,000 
$192,000 
$153,000 
$151,000 
NOI 
$15,418 
$15,879 
$19,466 
$14,120 
$13,225 
Capitalization
Rate 

8.97% 
10.14% 
9.23% 
8.76% 
We include the 3plex because it has about the
same size units as the subject property, is a very recent sale, and is more
comparably located than any of the other properties.
You will note that we have included data
about each property (age, distance, sale date, etc.) that could be
used to weigh the results. That is, the cap rate could be influenced
more by some comparables than others when reconciling the results.
However, for our example, we will simply average the four numbers (divide
the sum of them by 4) to obtain a capitalization rate of 9.27 percent,
rounded to 9.3 percent.

