Summary:

The capitalization approach, a fundamental method in property valuation, estimates the fair value of an asset, such as income-producing real estate or a business, by calculating the net present value (NPV) of expected future net profits and net cash flow, referred to as Net Operating Income.  This method, commonly known as the income approach, is a vital tool in the real estate industry.

Article:

Understanding the income capitalization approach (Cap Rates) in property valuation is not just a theoretical exercise.  It’s a practical necessity when investing in income-producing real estate or obtaining a loan.  This knowledge is not just useful; it’s essential for commercial realtors, lenders, developers, and investors in income-producing real property, equipping them with the tools to make informed decisions in their day-to-day professional roles.

Net income divided by the capitalization rate will reflect the expected value of the income-producing asset.  Re-stated: Net operating Income divided by the capitalization rate = value (NOI/Cap Rate = Value).

Example: Property Income and Expense Statement Format

The calculation to arrive at the Net Operating Income

Potential gross income XXXX

Contract rents (tenant-occupied spaces) XXXX

Escalation income XXXX

Market rent * XXXX

Other income XXXX

Total potential gross income(PGI) $ XXXX

Vacancy and collection loss & rental concessions (V&C) - XXXX

Effective gross income(EGI) = $ XXXX

Operating expenses

Fixed $ XXXX

Variable XXXX

Replacement allowance XXXX

Total operating expenses(OE) = - XXXX

Net Operating Income(NOI) ** XXXX

Total annual debt service(ADS) - XXXX

Pre-tax cash flow(PTCF) $ XXXX

*Market rents should be used for rents attributed to vacant space, lease renewals, and owner-occupied space:

** Depreciation, capital expenses, and loan costs are not considered in the calculation of the NOI

As stated again, the capitalization Rate represents the annual Net Operating Income (NOI) divided by the cap rate to derive the property asset value (NOI/Cap Rate Value).

Why use Capitalization Rates?

The capitalization approach is a comparative method for valuing properties with similar characteristics, including income streams, geographic locations, and risks, that will yield a comparable rate of return.  Once the value is established, the comparative method can calculate the loan-to-value to determine if the property value falls within the lender’s loan underwriting guidelines.

The capitalization approach is calculated as if the property is debt-free.  The value will be the same whether the property has leveraged debt or is debt-free.  It represents a snapshot of the market valuation for the investment and does not account for loan debt service payments or financing costs.  The cap rate method is only one metric.

If investors finance their acquisition, as most do, further analysis, such as cash-on-cash return, will be helpful.  Sophisticated investors and loan underwriters may also calculate an Internal Rate of Return.  These calculations help establish that the property is income-producing and a worthwhile investment.

A licensed commercial appraiser may conduct a rent survey to determine the market rent for a specific property type within a given geographic area.  Market rents, which may or may not align with actual rents, also known as contractual rents, play a crucial role in the valuation process.  Understanding these concepts is not only essential but also critical, as it enables the audience to feel more informed and aware of their significance in the valuation process.

I once underwrote a loan transaction on a 100-year-old industrial building near San Francisco.  The property has a long-term lease at $0.18 per square foot, while the current market rent is $ 1.75 per square foot.  Since current market rents were much higher, the valuation metric was based on calculating the net operating income using the locked-in lower rental rate.  The property value reflected a significantly lower result than the actual property value using current market rates.

A property owner may own a property using one title method, such as The Archie Bunker Corporation, and occupy all or a portion of the building using a different title method, such as Archie Bunker Limited Liability Company.  He may charge himself above- or below-market rents for tax purposes.  Actual rents may also be higher than the market.  In this case, the appraiser would use market rents rather than actual rents to determine the capitalization rate (Cap Rate).

There are other instances where a capitalization approach is inappropriate.  For example, in the case of original ground-up construction, the alternative method is a discounted cash flow analysis.  The building cost and the cash flow from a lease-up will be projected over a reasonable time to the point of stabilized occupancy.   This is done by a competent appraiser who can construct a model to estimate future projected cash flows and use net present value discount formulas to determine the capitalization rate.  The result may differ from the market comparison method.  Understanding these instances is crucial for comprehensively understanding the valuation process, making the audience feel more knowledgeable and prepared.

Suppose you have income properties with similar characteristics in a geographically close location, that are sold in arm 's-length cash transactions, and the income stream data is available.  In that case, web-based databases track comparison capitalization rates (Cap Rates).

Market rents are the amount that can be expected for a property compared to similar properties in the same geographic area.  Contract rent, or actual current rent, refers to the amount for which the same units are being rented today.  Understanding this crucial difference is not only significant but also essential for accurate property valuation, as it can make the audience feel more knowledgeable and prepared for the valuation process.

There is an essential difference between market rents and current actual(contract) rents in the Cap Rate valuation process.  Compare two identical buildings, both well-maintained.  The first property is rented at a market rate, while the second building has deferred maintenance.  “Deferred maintenance’ refers to the necessary repairs and maintenance that have been postponed, which can significantly affect the property’s value.  The property with deferred maintenance is rented at under-market rates of under 30%.  In both cases, a lender and the appraiser will use market rents to determine the (NOI).  The assumption about the second building is that a new owner will upgrade the building and adjust the rents upward to a market rate.  The value of the second building would be adjusted downward or discounted to offset the cost of curing (i.e., upgrading the building).

The only time a lender or appraiser would use the lower rents is when those rates are locked into a long-term lease or a rent-controlled property.  ‘Locked-in rents’ refer to fixed rental rates for a specific period, often due to a long-term lease agreement or rent control regulations.  For instance, I once underwrote a prospective loan for an industrial building in Richmond, California.  The property was leased for a fee and subsequently leased to a third party for a term of 99 years, with 50 years remaining.  The locked-in rent was only 18 cents per square foot triple net.  The property owner and broker argued belligerently that the current value should be based on today’s rent, which was a much higher rate.

An inconvenient fact in this example is that the property owner is locked into an 18-cent-per-square-foot monthly income stream for the next 50 years.  Capitalized rents will be based upon an 18-cent-per-square-foot lease rate.  The capitalized value with an 18-cent-per-square-foot lease rate will have a dramatically lower NOI compared to a similar building next door that rents at a monthly rate of $1.75 per square foot.

Many historical rent comparison databases are available to determine market rents, allowing for a correct capitalized valuation.  Historic market Cap rates may vary, even in the exact geographic location, depending on factors such as building improvements, effective age, class of construction, off-street parking, furnished or unfurnished status, condition, compliance with zoning, easements or lack of needed easements, and amenities.  Examples include Class-A vs. Class-C offices, industrial apartments, older, dated, and economically obsolete buildings,  as well as those with inadequate parking compared to newer modern buildings with currently popular amenities.

Capitalization Approach to Value: Advantages and Disadvantages.

Advantages:

• This method converts an income stream into an estimate of the value of the income-producing real estate.
• The method is a typical appraisal, lending, and development standard.
• < UNK> The income capitalization approach is common in evaluating commercial income-generating properties, but it can be applied to any income stream, including businesses.
• Commercial appraisers are a reliable source for determining market cap rates.
• Commercial realtors provide an excellent source of cap rates through websites such as CoStar and CREXi.
• There are online database,s such as the CBRE/US-Cap-Rate-Survey-Special-Repor,t to obtain reliable data.

Disadvantages:

• The method is used for comparison only with similar properties in a close geographic area.  The process does not consider liens on the property or debt service.  A cap rate calculation is performed as though the property is debt-free.  Cap rates cannot be used to calculate overall net cash flow or cash-on-cash yield when a loan is attached to the property (Income, fewer operating expenses, less debt service).
• The results of a cap rate calculation are specific to a similar area with similar properties in a particular market segment.  You cannot use Newport Beach, California, cap rates to compare with an identical building with similar usage in Little Rock, Arkansas.  Additionally, the demand for properties and cap rates varies across different real estate market segments.  Current examples include residential income properties and industrial properties, which are and will continue to be in demand.  I read that one estimate predicts industries in the US will require an additional 1 billion square feet of warehouses by 2025.  Office and lodging/resort-related properties are not doing so well.  Patterns change!
• The method contemplates stable economic conditions. If a market experiences a significant downturn, collapses, or is subject to extreme political uncertainty, the market capitalization rate calculations may become irrelevant.
• Relying on a cap rate with unstable market conditions is difficult.  Using market rents may become suspect due to higher foreclosure rates, tenants defaulting more frequently, increased vacancy rates, and replacement tenants requesting higher rent concessions, which can cloud the market rent.  Additionally, owner operating expenses may fluctuate.
• Calculating and forecasting future income streams involves high subjective judgment and is subject to variability.
• Professional judgment is subject to subjective versus objective interpretations of expectations for future benefits.
• The method may result in miscalculations when estimating the cost of capital outlay for upgrades to bring the property up to current standards.  All job subsets have a price, time, and frustration allocation, including government regulatory intervention, state-level and municipal approvals, building reconstruction, modern materials, safety, zoning, environmental, and imposed social equity requirements.
• A comprehensive analysis is required for property amenities, parking, easements, recorded encumbrances, and compliance with building and zoning regulations.
• The lease-up period is an estimate only and may not be accurate.
• Alleged appraiser and lender biases for racially segregated neighborhoods have been known to exist.
• Tenancies: landlords and tenants may enter into four types of rental or lease agreements.   The type depends upon the agreed-upon terms and conditions of the tenancy.  All rental amounts and lease terms will be reflected in the capitalization evaluation.

Types include:

• A fixed-term tenancy is a type of tenancy with a rental agreement that has no specific end date.  Fixed-term contracts have a start date and an end date.  According to the written lease document, terms such as ten years with multiple extensions may be short or long.
• A landlord cannot raise rents or change lease terms because the terms are codified in a written agreement.  A key advantage for a landlord is receiving today’s market rents.  A key for a tenant is locking in a long-term lease where the rent is or becomes below market over time.

A tenant company’s net profits may be enhanced by paying substantial under-market rents based on a long-term lease.  On the other hand, if a tenant company makes a good profit with rents substantially below market and a lease is coming due soon, the increased or negotiated upward lease rate may wipe out some or all the profits.

• A periodic tenancy has a set ending date.  The term automatically renews into successive periods until the tenant notifies the landlord that they want to end the tenancy.  Month-to-month tenancies are the most common.
• The strength of tenancie, ranging from national credit with long-term leases and corporate guarantees to mom-and-pop month-to-month tenancie, will result in a substantially different Capitalization Rate.  National credit tenants with corporate guarantees have a considerably lower cap rate.  M-m and pop tenancies will reflect a higher cap rate because they inherently have more risk.

The lower the market Cap Rate, the lower the perceived risks of property ownership.  The higher the market Cap Rate, the higher the perceived risks.  An exception would be where the national credit tenant locks in a lease rate that does not increase as the market dictates or anticipates increases.   Eventually, over time, this tenant will reflect below-market rents.

A mom-and-pop tenant could be converted to a market rent quickly because the term is usually shorter.

Market rents are obtained through surveys of local brokers and appraisal databases, which provide information on local market rents.

• Tenancy-at-sufferance(or holdover tenancy).  This form of tenancy is created when a tenant wrongfully holds over past the end of the tenancy period.
• I bring up this type of tenancy because of the manufactured COVID-19 fiasco.  The government allowed tenants to skip out and default on paying rent without consequence. The tenants either defaulted on the rent or overstayed the term.   Either way, the tenant becomes delinquent, and the owner attempts to evict them.  The tenant or affiliates may become illegal trespassers.
• There are numerous examples of landlords attempting to evict illegal tenants, only to be frustrated by the court system, which often results in multiple appeals being requested by the tenants.  Stalling tactics were usually granted.  Then came various bankruptcies, not only of each tenant, one by one, but also of unknown parties who supposedly moved in without notice to the landlord.  Then came the transients and fictitious individuals who claimed to be tenants and requested that the process be restarted due to their fraudulent tenancy claims.  The courts, particularly in states like California, tend to disregard this behavior.
• The property owner’s focus becomes using legal avenues to evict the tenants and regain property occupancy.  This process has significant costs and frustration.
• Tenancy-at-Will. This form of tenancy reflects an informal agreement between the tenant and landlord, where the landlord grants permission, but the duration of occupancy remains unspecified.  The term will continue until one of the parties gives notice.

Property Rehabilitation and New Construction:

Establishing market rents becomes essential in underwriting a rehabbed or new building.  When there is an extended lease-up period delay, such as with the new construction of an income-producing property, future cash flows need to be estimated to the point of income stabilization; then, the future stabilized income will be discounted using an estimate of a market capitalization rate and a discount rate formula.

Please work with a competent commercial appraiser to help calculate the right market Cap Rate.   Please don’t try to do this yourself without an appraiser who is familiar with the type of real estate and the local market.

Below is an example: The market capitalization rate (Cap Rate) for a commercial property with triple net leases (NNN) has been determined to be 6.5%.  Triple Net (NNN) refers to a leased or rented property where the tenant pays all expenses related to the operation, such as taxes, insurance, maintenance, and occasional capital improvements.  The 10,000-square-foot multi-tenant property under consideration generates monthly rents of $1.50 per square foot.  In an (NNN) example for a Cap Rate analysis, one would apply a 10% vacancy collection and loss factor, as well as a 5%factor  for non-chargeable expenses that tenants usually do not pay, including reserves.  The NOI would be $153,900.

The NOI and Market Cap Rate are known, so you can calculate the value:

10,000 SF rentable X $1.50 = $15,000 Per mo. X 12 Mos. = $180,000 = potential gross income.

$180,000 $18,000 for 10% vacancy = $162,000 $8,100 for 5% non-chargeable expenses to the tenants = NOI = $153,900

$153,900 NOI /.065 Cap Rate = value = $2,367,692

From an investment standpoint, market Cap Rates can show a prevailing rate of return at a time before debt service.  The cap rate procedure helps lenders and investors measure returns on invested capital and profitability based on cash flow.  An informed lender or investor should understand that there may be dramatic variations in a property’s value when unsupported or unrealistic Cap Rates are applied.

Cap Rates and demand for income-producing properties will fluctuate depending on market conditions.  Cap Rate compression reflects a downward movement in the rate because investors perceive real estate as a lower-risk, higher-reward asset class relative to other investment options.  Cap Rate decompression may result from demand for real estate purchases, where cap rates increase, reflecting lower valuations.  This may be a byproduct of higher interest rates or government intervention, such as rent control.

Loan-To-Value Ratio (LTV):

Review:

• The ratio between a mortgage lien(s) and the property’s value pledged as security for the loan is usually expressed as a percentage (%).
• Loan divided by Value = Loan to value = $500,000 = 33.33% $1,500,000
• The loan expressed as a percentage of the value = 33.33%
• Use the relationships to find the unknown constant.
• To find the LTV, divide the loan amount by the property value.
• To find the Loan: LTV x value = Loan

To find the Value Loan divided by LTV Value

• Cash-on-Cash Return:

Cash-on-cash returns provide a quick analysis to determine the yield of an initial investment.  Hey, they are calculated by dividing the total cash invested (the down payment plus initial cost) or the net equity by the annual pre-tax net cash flow.

Assume the Borrower purchased the property, which costs $1,200,000 and provides an NOI of $100,000, with a $400,000 down payment representing the equity investment in the project.  The cash-on-cash return for this property would be:

$100,000/$400,000 = 25% = cash-on-cash yield.

If the Borrower were to purchase the property for all cash, as contemplated in a Cap Rate calculation, then the cash-on-cash return would be:

$100,000/$1,200,000 = 8% (in this example, the 8% is the cash-on-cash yield and Cap Rate).

This formula shows that leveraging or financing real estate transactions will yield a higher cash-on-cash return, provided the transaction is funded at a favorable interest rate.

Internal Rate of Return (IRR):

The internal rate of return (IRR) refers to the yield earned or expected to be earned on an investment during its entire ownership period.  IRR for an investment is the yield rate that equates the present value of the capital outlay and future dollar benefits to the amount of money invested.  IRR applies to all dollar benefits, including the outlay of the initial down payment plus cost, the positive monthly and yearly net cash flow, and positive net proceeds from a sale at the termination of the investment.  IRR measures the return on any capital investment before or after income taxes.  Ideally, the IRR should exceed the cost of capital.

Is there an ideal Cap Rate?

Each investor should determine their risk tolerance to reflect the ideal risk-reward level of their portfolio.  A lower capitalization rate (Cap Rate) means a higher property value.  A lower Cap Rate would imply that the underlying property is more valuabl,e but may take longer to recapture the investment.  If investing long-term, one might select properties with lower Cap Rates.  If investing for cash flow, look for a property with a higher capitalization rate (Cap Rate). Declining Cap Rates may indicate that the market for your property type is heating up, with demand intensifying.   Or, for Cap Rates to remain constant on any investment, the rate of asset appreciation and the increase of NOI it produces will occur in tandem and at the same rate.

NOI, Cap rates, and value

Below are examples of changes in NOI and Cap Rates that cause asset values to rise or decrease:

Asset values will increase as NOI increases and Cap Rates remain the same.

(Rising NOI-net operating income and .06 reflects a 6% cap rate)

$300,000 /.06 = $5,000,000

$350,000 /.06 = $5,833,000

$400,000 /.06 = $6,666,666

$450,000 /.06 = $7,500,000

As NOI remains the same and cap rates rise, asset value will go down:

($500,000 reflects net operating income, and .03 reflects a 3% cap rate)

$5US,000 /.03 = $16,6US,666

$500,000 /.04 = $12,500,000

$500,000 /.05 = $10,000,000

$500,000 /.06 = $8,333,333

Correlation Between Cap RUSes and US TreasurUSs:

The US ten-year Treasury Note (UST) is deemed a risk-free investment against which returns on other types of investments can be measured.  As interest rates increase, investors who purchased USTs at a lower rate will find that their bonds will decrease in value.  Bonds purchased at the ne,w higher rates will be in high demand.

As interest rates rise, cap rates increase, and asset value decreases over time.  With so many uncertainties in the market and growth projections constantly being revised, the spread between UST and Cap Rates has not remained constant.

When the government intervenes in market forces, the results become artificial.  This has led to a decrease in capitalization rates, reflecting higher property values.  Near-zero interest rates have also caused a dramatic inflationary spike in all goods and services.

Conclusion:

Property appreciation from excess demand has been one of the most significant reasons for investing in real estate.  Appreciation is not part of the Cap Rate calculation.  For investors, lower interest rates and the tax benefits of owning commercial real estate may be the driving force behind such an investment.   If the property is to be leveraged, there may be write-offs for loan fees, interest, operating expenses, depreciation, and capital expenditures.

As interest rates have been forced down to meager rates, below the inflation rate, by government mandate.  Refinancing at lower rates has resulted in lower debt service payments.  Cash flows of income-producing properties have increased, reflecting a higher net operating income.

The government intentionally creates market distortions that benefit the insiders at the top of the economic spectrum.  The results are artificial.  This has led to a decrease in capitalization rates, reflecting higher property values.  Near-zero interest rates have also caused a dramatic inflationary spike in all goods and services.  All asset classes have now been spiked with 200-proof illusions that make everything seem fantastic on the surface.  But hangovers the day after the party ends are no fun.

Interest rates have more than doubled, shattering the economic punch bowl into fragments.  Continued interest rate increases will cause the economy to collapse overnight.  Main Street and small capitalist entrepreneurs will bear the brunt of widespread financial damage.

Interest rates are increasing because the government realizes that inflation will only accelerate if it does not stop or slow down.  Increased interest rates will result in newly originated loans having higher payment structures.  Higher loan payments indirectly and over time cause cap rates to rise and values to decrease.

Values may not decline immediately, but the demand to purchase income-producing properties will subside because ownership becomes less economically sensible.  To add flames to this fire, the federal and state governments pass legislation that will destroy investors’ motivation to own.

Over time, the four-pronged whammy will become apparent.

• Rising interest rates,
• Increase in interest rates reflecting larger loan payments,
• General loss of investor confidence in the overall economy,
• Loss of investor interest in purchasing an income property,
• Overburdening & abusive government intervention in property ownership will come home to haunt the entire real estate market across the United States.
• All of the above will cause cap rates and property values to decrease.

Remember that increased debt service based upon higher interest rates is not considered in the capitalization approach.  However, as interest rates rise, borrowers will feel the sting of higher debt service payments.  Some property transactions may become less appealing financially, as purchasers and borrowers elect not to purchase, which may compound and create more unsold inventory.  Some sellers may become desperate and reduce the price to sell their items quickly.  The lowered price would result in a higher capitalization rate.  The interest rates will lower all real estate prices on a macro level.

How dramatic will lower real estate prices be over time?  Between 2007 and 2010, we witnessed the downward value contagion spread, resulting in substantially lower values and increased Capitalization Rates.

The four-pronged whammy is not a new phenomenon.  It has just been forgotten while enjoying the Federal Reserve’s free-for-all, 200-proof-infused financial punchbowl.