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					       Capitalization Rate Development
          Basic Techniques and Sources for Cap Rate Information

Sponsored by the Middlesex County Assessors Association
What is a Cap Rate?

Any Rate used to convert
    income into value.
     What is a Cap Rate?
             Formal Definition
Capitalization is the process of converting income from
a property into an expression of capital value. Therefore,
a capitalization rate is nothing more than the
mathematical relationship between the income and the
capital value. There are two basic methods of
capitalization: the direct method and the yield method.
There are many rates that are used in capitalization.

                    The Appraisal Institute
        Types of Capitalization

•   Gross Rent or Gross Income Multiplier
•   Band of Investment
•   Debt Coverage Ratio
•   Overall (Direct or Market Derived) Cap Rate
•   Yield Ratio
    – Discount Rate
    – Internal Rate of Return (IRR)
    – Equity Yield Rate
     Band of Investment
           What is it?

It is a blending of the weighted
 rates of mortgage and equity
        into an overall rate.
       Band of Investment
          Major Advantages
The information required to calculate a
cap rate via the Band of Investment
technique is readily available.

Considers both equity and financing
       Band of Investment
          Major Disadvantages

The Band of Investment technique has a
powerful financing influence.

It is easy to misapply dividend rates to
properties that are not comparable or use
financing terms, or financing ratios, that
are not typical for the property type.
       Band of Investment
     Components and Calculations

Assumes an investor would pay cash for
a portion of the property and finance the
remaining balance of the purchase price.

The cash portion is known as the “equity”
component and the financed portion is
known as the “Debt” component.
             Band of Investment
Holding Period:
The length of time the typical investor expects to hold the property.
LTV (Loan to Value - M):
This represents the loan or debt portion of the property investment in terms
of a percentage.
Equity Dividend (Re):
The "cash on cash" return (usually reflecting the first year) that measures
the portion of income remaining after satisfying all expenses including
mortgage debt to the initial down payment.
Equity Yield (Ye):
The annualized total return an investor would desire from the property
(required rate of return on and of equity capital).
           Band of Investment
Mortgage Constant (Rm):
Mortgage constant is a rate that reflects the periodic annual
payment of principle and interest on a mortgage with a level
amortization schedule that will extinguish the debt.

Mortgage Rate:
Mortgage Rate is the annual interest rate lenders charge when
making real estate loans.

Mortgage Term:
Mortgage term is the number of years for which the mortgage was
         Band of Investment
             Mortgage Constant

The mortgage constant is calculated using the
interest rate and term of financing.

The mortgage constant can be calculated using a
financial calculator such as the HP12C or

By using the PMT function on an excel
            Band of Investment
                 Mortgage Constant

The excel PMT function is expressed:
=PMT(Interest Rate expressed monthly, term in months, amount)

To calculate the constant, simply use the following
 Where cell C1 is the interest rate and C2 is the term.
  Band of Investment
Mortgage Constant Calculation

Mortgage Rate:      6.50%
Term:                   20 years
    Mortgage Constant Calculation
=PMT(C1/12,C2*12,-1)*12 0.08947
    Band of Investment
Mortgage Rate:6.50%   Equity Dividend:   10.00%
Term: 20 years        DCR                1.25
L/V Ratio: 80.00%     Equity Portion:    20.00%

Portion Ratio Rate     Weighted Average
Debt    0.80 * 0.08947 =     0.071575
Equity  0.20 * 0.10000 =     0.020000
            Weighted Rate        0.091575
       What is missing from
       our BOI Calculations?
• Ellwood Model
    – Change in value during the holding period
    – Change in income during the holding
•   Variable Rate Financing
•   Going In vs. Going out Caps
•   Mortgage Equity Changes
•   The Tax Factor
             Tax Factor
• Why do we include the tax factor in the
  cap rate and not as an expense?
• How do we apply the tax factor?
• Tax rate =$10.00 what is the tax factor?
  – $10.00 per thousand represents .0100 cap
            Tax Factor
Basic Rate (BOI)       0.0915
Tax Factor             0.0100
Cap Rate via the BOI   0.1015

Debt Coverage Ratio
 Major Disadvantage

  There is no equity portion.

 Predominantly used by lenders
to determine risk and feasibility.
      Debt Coverage Ratio
      Components and Calculations

• The information required to calculate
  the cap rate via Debt Coverage Ratio
  technique is very similar to the Band of
     Debt Coverage Ratio
Most lenders require DCR between 1.10 and 1.30
                 Our example
       DCR = 1.25        LTV = .80
        Mortgage Constant = 0.8947
     Debt Coverage Cap Rate Calculation
     ((1.25 * .80) x 0.08947) = 0.08947
                   Tax Factor   0.01000
                   Cap Rate     0.09947
    Direct Capitalization
Provides assessors and appraisers
with a strong measure of a cap rate.

   Cap Rate = NOI ÷ Sale Price
        Direct Capitalization
 Appears simple but avoid potential pitfalls

• There are many methods to calculate NOI.
• This method does not consider the yield or
  rate of return of the property. It simply
  represents the relationship between one
  years income and the sale price.
• Review sales and subject.
       Direct Capitalization
Appears simple but avoid potential pitfalls

• Review the sales and subject
  – comparable properties should have similar
    investment features, expense ratios,
    financing, ages, and types of properties.
  – Use several sales (at least 4 or 5) to
    establish trends
  – Review NOI for each sale and the subject
        Direct Capitalization
Appears simple but avoid potential pitfalls

• The NOI must be calculated the same for all.
• Review lease start dates. Beware of old
  leases. Remember assessors are appraising
  fee simple. Older leases may represent
  leased fee.
• Always test the Cap Rates for
            Tax Factor

• As with the other capitalization
  techniques, the taxes should be
  represented as a factor added to the
  cap rate.
• Do not include taxes as an expense
  when as an expense when calculating
  the NOI.
       Information Sources

• Testing the numbers for
  reasonableness requires assessors to
  collect as much information as possible.
• The best sources to verify sale and
  income information are the buyers,
  sellers and brokers.
      Information Sources
   There are many other sources
• Local and National Real Estate Brokers
  and Management Publications.
• Local Bankers
• Newspapers
• Other Assessors and Appraisers
         Information Sources
         PWC Korpacz Investor Survey
•   Excellent source for general cap rate and
    income information.
•   Beware of disclaimer and NOI calculation
•   Always verify the information using local
         Information Sources
       Master Money Matrix published
           by Fantini and Gorga

• Provides mortgage and lending information including
  rates, LTV ratios, Debt Coverage Ratios, and typical
  mortgage terms for multiple property types.

Excellent source for rate and investment information.
                     Updated daily.

                 December 31st
                  January 2nd
         Information Sources
     National Investor Center for Senior
          Housing and Care Industry

• Provides key financial indicators including
  capitalization rates for senior housing and care
  including nursing homes, assisted living, and
  continuing care residential units .

        Information Sources
National Investor Center for Senior Housing and Care Industry
        Information Sources
National Investor Center for Senior Housing and Care Industry
          Information Sources
Building Owners and Managers Association

       Experience Exchange Report
Provides detailed building income and expense information.

Information Sources
          Information Sources
      International Real Estate Managers

         Income /Expense Analysis
Provides detailed building income and expense information.

Information Sources
           Information Sources
  Prim e Rate
                  2000          2001    2002        2003      2004      2005
     Jan         8.50%         9.50%   4.75%       4.25%     4.00%     5.25%
     Feb         8.50%         8.50%   4.75%       4.25%     4.00%     5.50%
     Mar         8.75%         8.50%   4.75%       4.25%     4.00%     5.75%
     Apr         9.00%         8.00%   4.75%       4.25%     4.00%     5.75%
     May         9.00%         7.50%   4.75%       4.25%     4.00%     6.00%
     Jun         9.50%         7.00%   4.75%       4.25%     4.00%     6.25%
     Jul         9.50%         6.75%   4.75%       4.00%     4.25%     6.25%
     Aug         9.50%         6.75%   4.75%       4.00%     4.50%     6.50%
     Sep         9.50%         6.50%   4.75%       4.00%     4.75%     6.75%
     Oct         9.50%         6.00%   4.75%       4.00%     4.75%     6.75%
     Nov         9.50%         5.50%   4.75%       4.00%     5.00%     7.00%
     Dec         9.50%         5.00%   4.25%       4.00%     5.25%

Constant Maturity Treasury                     12-Month Treasury Average (MTA)
Certificate of Deposit Index                   Cost of Savings Index (COSI)
Prime Rate                                     Fed. Funds Rates
                                Discount Rates
 Information Sources
Real Estate Research Corporation
Information Sources
  Information Sources
               Other Sources
                  NAI Hunneman
                  Spaulding & Slye
                     Grub & Ellis
                U.S Realty Consultants
Federal Reserve Bank (New England Economic Indicators)
                  Finard & Company
       The Warren Group (Banker & Tradesman)
                 Meredith & Grew
                 Codman Company
• Always confirm your data
• The best information is derived from market
• Use your income and expense data.
• Check for reasonableness.

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