What is the Cap Rate of Capitalization?

Capitalization is the process of converting the estimated annual net operating income of a property into an estimate of market value.
The rate used in the capitalization of income is the annual rate of return from a property that an investor demands before he or she will purchase that property. Capitalization rate is a composite of the interest rate (return on an investment) and the recapture rate (return of an investment).

The formula used to compute present value is:

      Net Income            = Present Value
Capitalization Rate

Real estate compete with all other types of investment for available investment funds. When appraisers estimate the rate of return (capitalization rate) demanded by investors, they must consider many characteristics of the investment (which is individual property, in this case). The main items are described below.

1. Reliability of Net Income-The appraiser must evaluate certainty of future income and expenses. A property on a long-term net lease to a responsible lessee is more desirable and would probably attract capital funds at a lower rate than a similar property on a month to month tenancy.

2. Liquidity-An investment that can be readily sold, such as stocks and bonds, is usually preferable to an asset like real estate or machinery that may require weeks or months to sell. Similarly, an investment that can be acquired in relatively small denominations has much wider market of prospective purchasers than a larger investment.

3. Burden of Management-In this case, we mean general supervision and care of the investment, not management of the type that would be deducted from the income as an operating expense. Investment assets require different degrees of management. Bonds and mortgages require virtually none. A real property under a long-term net lease requires less management than a property under a month to month tenancy.

4. Probability of Increase or Decrease in Value-The probability of a change in value varies with the type of investment and individual asset. Bonds and mortgages are likely to remain stable in capital value. If the buyers and sellers anticipate an increase in the capital value of an asset, the present yield rate will be less than the rate for an asset of stable or decreasing value.

5. Taxation-The income tax treatment of anticipated future benefits from an investment can influence the capitalization rate. Tax-free municipal bonds are purchased at a lower yield rate than similar taxable bonds. Real estate may benefit from a depreciation allowance for improvements. Investments in real estate and corporate stocks may also be preferred because a gain at the time of sale will be treated as capital gain.

6. Hypothecation-Being able to use a capital asset as collateral for borrowing money is an advantage. Assets that fluctuate rapidly in value do not normally serve as good collateral.

Just as real estate competes with other investments for capital funds, each parcel of real estate competes with other parcels. Capitalization rates for real property vary with type, age, and condition of the property, location, and surrounding development, and existing economic conditions. The more secure the future net income, the lower the capitalization rate. A lower rate would be used in capitalizing the income from an apartment house in a well-maintained and stable neighborhood than in an area of declining socio-economic conditions. The difference in capitalization rates would reflect peoples judgment of the quality of the properties in relation to the features we listed for a good investment. In an undesirable neighborhood, the capitalization rate might be higher because the reliability of income is poorer, the probability of appreciation in value is less and the burden of management is greater.

The appropriate capitalization for the subject can be estimated after considering the preceding considerations. Capitalization rates for competing real estate investment are found by dividing the net operating income of the property into the sale price.

Net Income       =Rate
Sales Price

The overall capitalization rate has been extracted from the comparable sales information that ranged from 6.8% to 9.5%. The subject contains an average location, being located on a street with average car and foot traffic. Although, the subject is 100% occupied, and has good space planning, as each tenant receives a storefront window. The subject is composed of average condition, and contains a good floor plan/ layout. The subject is surrounded by several buildings of the subject’s type. The subject’s rents are toward the bottom of the market levels and are competitive with the surrounding buildings. The subject’s estimating expenses are typical for a building of this type.

Since the subjects rents are toward the bottom of the range, and the subject is 100% occupied. It’s risk is felt to be toward the lower end of the range of the comparable sales. The appraiser analyzed the comparable sales and the subject, and felt that the subject contained a slightly lower risk due to its rents and being 100% occupied. Thus, a capitalization rate of 8.0% is felt to be appropriate for the subject property.

Thus,

Income        =Value
Rate

$77,377        =$967,213
   .08

Rounded: $970,000