# Cap Rate

In real estate investment analysis, cap rate (short for capitalization rate) equals the ratio of net operating income to the property value. Cap rates from comparable properties are used to discount the net operating income of a property to arrive at its intrinsic value.

Just like any other investment, real estate is valued at the present value of its future cash flows. There are two methods used to value real estate: direct capitalization method and discounted cash flows method. In the direct capitalization method, the income stream of a property as measured by the net operating income is considered a perpetuity and the property value equals NOI divided by a discount rate.

## Formula

The value of property in direct capitalization method is determined using the formula for present value of perpetuity:

$$\text{Value}=\frac{\text{NOI}}{\text{r}}$$

r above is the cap rate and NOI stands for net operating income. It inherently incorporate the growth rate of NOI in the calculation. Cap rate r equals the discount rate i minus the growth rate g.

By rearranging the above equation, we get the mathematical expression for r:

$$\text{r}=\frac{\text{NOI}}{\text{Value}}$$

The cap rate r is determined based on the ratio of the net operating income (NOI) to the value of comparable properties. NOI equals the property revenue minus all operating expenses such repairs and maintenance, insurance, property taxes, utilities, etc. NOI is an unlevered measure of net cash flows i.e. it doesn’t subtract any interest expense or any other capital charges, and so is the property value and cap rate.

The cap rates used to value a property must be from property transactions which are very similar to the property being valued in terms of the property’s location, size, nature of the property (residential vs commercial), lease term (short-term or long-term), age i.e. whether renovations and improvement costs are identified, etc.

## Example

Given the following data, value Property A using cap rate derived using information available for sales of Property B and C whichever is most appropriate.

Property A B C
NOI $1,000,000$2,000,000 $15,000,000 Value ?$25,000,000 \$150,000,000
Lease term 10 years 8 years 3 years
Number of tenents 2 3 10

Property B is more like Property A than Property C hence we should value Property A using cap rate derived from value and NOI information of Property B.

$$\text{Property B Cap Rate}\ (\text{r} _ \text{B})\\=\frac{{\rm \text{NOI}} _ \text{B}}{\text{V} _ \text{B}}=\frac{\text{\2 million}}{\text{\25 million}}=\text{8%}$$

$$\text{Value of Property A}\ (\text{V} _ \text{A})\\=\frac{{\rm \text{NOI}} _ \text{A}}{\text{r} _ \text{B}}=\frac{\text{\1 million}}{\text{8%}}=\text{\12.5 million}$$

The cap rate used above can be adjusted up or down considering differences between the comparable property (i.e. Property B) and the property being valued (i.e. Property A).

by Obaidullah Jan, ACA, CFA and last modified on
Studying for CFA® Program? Access notes and question bank for CFA® Level 1 authored by me at AlphaBetaPrep.com

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