Cap Rates and Tracking Market Trends

Article excerpt

The topic of capitalization rates, yields and market trends is both simple and complex to understand. We know, for example, that in concept a capitalization rate is income divided by the price paid. More specifically, an overall cap rate is a propert's net operating income divided by the price paid for the property-in symbols R0=NOI / P. Similarly, the cap rate for equity is the income to equity (before-tax cash flow) divided by the price paid for the equity interest (Re =BTCF / Pe), and the cap rate for a mortgage is the annual debt service divided by the amount of the loan (Rm = ADS / Vm). While there are a number of methods for estimating an Ro, such as direct market extraction, simple mortgage-equity, the Akerson format, the Ellwood formulation and the underwriters' method (Gettel), they are all designed to estimate the reciprocal of the net income multiplier-the multiple of net income that buyers are likely to pay for a property.

Furthermore, we know that a capitalization rate has two major components, a rate for the desired rate of return on the investment and a provision to provide for expected capital loss or enhancement. The well-known tendency for cap rates to remain relatively stable through the economic cycle is probably a result of the different operation of the economy on these two components. What is not known, however, is the nature of these operations and the true extent to which they offset each other.

While a forecast yield is a component of a cap rate, the yield obtained from a property is very different from the cap rate, first, because the yield is only one component of the cap rate, and, second, because the yield can, in reality, be known only after disposition of the property. …