The Truth About Cap Rates
Cap rates are used by market participants, brokers, and appraisers in estimating value of income producing properties. In professional valuation, the cap rate is formally referred to as the Overall Capitalization Rate (OAR). The Overall Capitalization Rate is an expression of the relationship between value and income. The “IRV” diagram is sometimes used to illustrate all the relationships that exist between income, rate and value.
To summarize; I (income) divided by R (rate) equals V (value). I divided by V equals R. And finally, R times V equals I. Therefore, to develop an indication of the OAR, the net operating income (NOI) of a property is divided by the sale price.
The best source of general cap rate information is the market. Appraisers and commercial brokers keep track of sales and their indicated capitalization rates. Different property types tend to have different cap rate ranges. At the time of this writing, cap rates in the Santa Barbara area generally fall in the range of 4.0% to 7.0%
The overall capitalization rate is not a property rating. Rather, the OAR is a rating of the perceived quantity, quality, and durability of the projected income. When considering the projected income, the valuer takes into account the balance between the exposure to risk and the potential for gain. The exposure to risk is an assessment of the likelihood that the projections will not be met. The potential for gain is an assessment of the likelihood that the projections will be exceeded. The perception of lower potential risk and/or higher potential for gain results in downward pressure on the rate.
In an all cash transaction, the OAR is a direct reflection of the return to the property owner. However, the market is dominated by situations where the potential return must be allocated between the buyer (equity position) and the lender (mortgage position). Therefore, looking at the return requirements of the two positions can be helpful in estimating an appropriate capitalization rate. This is called the “Band of Investment” method of evaluation of an overall capitalization rate.
Currently, mortgage interest rates are in the area of 4.0% to 4.5%. For a typical commercial property, the mortgage ratio is often in the area of 70%. Investors have two sources of potential return. They are the annual “cash-on-cash” return and the potential for equity growth through mortgage pay down and property appreciation. The two are related; the equity dividend rate (cash-on-cash return) used in the analysis is influenced by property appreciation expectations. Currently equity dividend rates are judged to be in the area of 7.0% to 8.0%. Mathematically, the calculation is expressed as follows:
Position Ratio Rate Extension
Mortgage 70% x 4.25% = 2.98%
Equity 30% x 7.5% = 2.25%
There is no empirical method of calculating an overall capitalization rate. From the point of view of a professional valuer, the analyses undertaken are helpful in pointing in the direction of what would be an appropriate capitalization rate to use in a particular situation. But, at the end of the day, the selection is careful professional judgement.
Mr. Arnold is a principal at Hammock, Arnold, Smith & Company. They are a general practice appraisal firm providing valuation and evaluation services to a variety of clients including corporations, government agencies, the legal community, financial institutions, private individuals and others.
Michael Neal Arnold, MAI, MRICS