# caprate

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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
The information required to calculate a
cap rate via the Band of Investment

Considers both equity and financing
aspects.
Band of Investment

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
Components
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
Components
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
given.
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
formula.
=PMT(C1/12,C2*12,-1)*12
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
period
•   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

or
10.15%
Debt Coverage Ratio
Technique

There is no equity portion.

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

• The information required to calculate
the cap rate via Debt Coverage Ratio
technique is very similar to the Band of
Investment.
Debt Coverage Ratio
Technique
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
reasonableness
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
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
methods.
•   Always verify the information using local
information.
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.

• http://www.fantinigorga.com
Bloomberg.com
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 .

• http://www.nic.org
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
BOMA

Experience Exchange Report
Provides detailed building income and expense information.

http://www.boma.org
Information Sources
BOMA
Information Sources
International Real Estate Managers
IREM

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

http://www.irem.org
Information Sources
IREM
Information Sources
RateEmpire.com
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
Realtyrates.com
Information Sources
Other Sources
NAI Hunneman
Spaulding & Slye
www.bostonapartmentmarket.com
CBRE
Grub & Ellis
U.S Realty Consultants
Federal Reserve Bank (New England Economic Indicators)
Finard & Company
The Warren Group (Banker & Tradesman)
Meredith & Grew
Codman Company
Costar
Conclusion
• The best information is derived from market
sources.
• Use your income and expense data.
• Check for reasonableness.

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